Are Value Stocks Waking Up from Hibernation?

In capital markets, most investors used to subscribe to one of two of the main doctrines, value or growth investing. Growth investors seek strong earnings growth often investing in stocks within a 10-year range of their IPO (a prudent estimate). Usually, the investors will value these companies using a projection of earnings by some multiple (or a similar metric to the same effect). Value investing hinges on finding “bargains.” Comparing price to earnings (or once again a similar metric), investors look for companies who have been undervalued by the market.

One important thing to note when investigating value or growth stocks is their age. When stocks have just gone through their IPO, they are very volatile and have large earnings growths. Over time, this growth is not sustainable, and the stock becomes a value stock. This oversimplification of the life cycle of a company raises an interesting question: if all growth stocks are destined at some point to enter the value market, why has value investing underperformed growth for the last decade?

The first, most referred to theory is that the emerging, capital light business models that personify growth investing (e-commerce platforms such as Uber and Netflix among others) continue to increase market share in a monopolistic manner. When we compare our value stocks to them, there is no reason or cause for them to return to previous valuation levels. As these growth stocks claim more and more of their Total Addressable Market, their earnings accelerate further and value stock’s returns pale in comparison.

Further suppressing value investing is the venture capitalist’s favourite word: “disruption.” The ability to disrupt markets is integral to start-ups, and with these powerful ecommerce platforms, there has been greater disruption than ever, destroying the business models of traditional retailers.

Third, these capital light businesses, due to their increased efficiency and scalable nature, have helped keep a lid on inflation. This has given central banks the ability to reduce interest rates to historically low levels. As we have seen over the decades, this lower cost of capital galvanises innovation and consumer spending, which are the backbone of growth stocks. Further, this economic atmosphere creates a risk-taking environment, which inevitably creates a few “unicorns.”

Lastly, capital markets have changed due to increased volume from non-institutional Investors. Trading 212, Robinhood, Revolut and many other services are making it easier and more popular for people to invest. Historically, these investors have opted for momentum strategies, taking advantage of exaggerated trends and breakouts. These strategies do not marry with the more long-term nature of value stocks.

This growth stock dominance may be coming to an end. Lately bond yields have been gaining steam and their climb will inevitably hurt the rate-sensitive growth stocks. This is not the only danger to growth stocks, in the previous quarters, blue chips and large caps made large moves. This top-heavy growth is often a sign of value investment opportunities that growth stocks will struggle to compete with.

There are also some who say that value stocks are so beaten down that all they need is a catalyst, which may be provided by global vaccinations. Given the current climate, this is the best chance that value stocks have had at a comeback since 2016 or possibly even in the last decade.