19 Aug Value, growth and rotation – what do these terms mean for share investors?
No one could blame investors for being confused at times by share markets and the industry jargon.
‘Value and Growth’ shares – what do these terms mean?
The tag’ value and growth’ refer to the underlying shares and the category to which the company can be broadly placed, based on how the shares are valued.
How or whether you invest in each of the categories is a contested issue in the investing community. The majority of experts and fund managers usually sit in the value camp.
Expert investors usually define value as cyclical shares that have a lower valuation (cheaper stocks), either in terms of a lower price to earnings ratio (PER) or a lower price to book valuation.
Growth refers to those companies that typically have higher revenue growth, lower or even no profits to loss-making. They can trade on much higher valuations, so much so that investors use other valuation metrics like the price to revenue (as the business is loss-making).
The share price can move in a direct correlation with the growth in revenue from these companies, i.e. high revenue growth equals higher share price, assuming multiple stays the same.
Value and cyclical shares typically trade on lower valuations. However, should the earnings growth improve with an economic upturn, then investors will rerate the PER. An example is moving from the current recession to recovery with the development of a vaccine.
In between growth and value, lies a term that can transcend both narratives, known as quality shares. Investors depict these companies as having several features. They look for a strong moat or competitive advantage, good governance, high levels of research and development, a propensity to embrace and practice ESG principles.
Quality companies can be either cyclical or growth but typically trade at higher valuations, because they have a more consistent earnings growth track record. There are some excellent examples in the healthcare sector, such as CSL, ResMed and Cochlear or Commonwealth Bank versus the other major banks.
Where are we now with the growth versus value narrative in a COVID world?
Investors have witnessed a growing contrast between the growth and value narrative with the evolution of the pandemic for two reasons.
One, the lockdowns have generally had the most harmful economic impact on cyclical companies such as travel, airports, property developers and banks (increased provisions for loan losses and margin pressure with lower interest rates).
Secondly, the lockdowns have brought forward future revenue streams for those businesses that had an online, e-commerce presence or have been able to transition swiftly to this business model. The ability to adapt to provide a click and go service or home delivery has been a critical marker for success.
The stay-at-home, work-at-home phenomenon has structurally changed the way society operates and how businesses deliver products and consumers shop.
Several companies have experienced an unexpected turbocharge in earnings.
A good example is a select group of retailers including JB Hi-Fi, Kogan, Temple and Webster, Adairs, Nick Scali and Baby Bunting that has benefitted from lockdowns and the stay, work-at-home economy. These companies have also benefitted from the fiscal stimulus packages of JobKeeper and JobSeeker.
Investors in the US share market have experienced similar themes. The e-commerce leaders Amazon, Shopify, Walmart and the ancillary services to the shopping platforms such as the contactless payments systems of PayPal and Square have shot the lights out in terms of sales growth and income generation. The same applies to the buy-now-pay-later companies in Australia like Afterpay and Zip.
The latest data quarterly data from the US Department of Commerce showed a 31.8% increase during the second quarter, from the previous quarter. E-commerce sales accelerated to 16.1% of all US sales up from 11.8% in the first quarter.
The most remarkable thing about the 2020 COVID economic downturn that distinguishes this recession from past economic contractions is the fact that governments have had to come to the party (fiscal stimulus). The intersection between health and economic outcomes has never been more intertwined.
For most investors, the share market is likely to remain sensitive to the tightrope between opening the economy and health constraints until a safe vaccine is available.
A case in point was Dominoes in the USA that announced the need for 20,000 delivery experts, pizza makes, managers and assistant managers. Here is a company that continues to shift to an online delivery food service at the expense of the smaller operators.
But for many commentators and politicians, the stimulus party is not infinite. The reduction or removal of the COVID stimulus measures begs the question for how long these types of retailers can shoot the lights out? And will the success of these online, e-commerce businesses continue to thrive?
What could cause the rotation to value shares from growth shares?
That is pretty simple to answer. It comes down to the bond market and what is happening predominantly with the 10-year US treasury interest rate. Share markets are highly sensitive to this barometer. If the long end of the curve, known as the 10-year US Treasury bond moves up or down, it can signify changing expectations about economic growth and inflation.
A higher US 10-year treasury yield indicates economic expansion and higher inflation down the track and the opposite when the interest rate falls.
Share markets had a brief taste of this starting in the second week of August. What may seem like a small move from a historical low of 0.52% in the 10-year Treasury yield just after August 8, to a near-term top of 0.72% on August 13 was enough to cause high flying growth shares to tumble anywhere from 10-25%. The laggards, by comparison, like Carnival Cruises and American Airline’s rallied by 22% and 27%, respectively.
Such moves were prompted by a slightly higher than expected July inflation reading and positive reports of an effective vaccine for COVID for the fourth quarter of 2020 in America.
Can you see the themes playing out?
The growth stories equated to the COVID winners as many adapted or already operated in the digital, e-commerce space. In comparison, value and cyclical shares have performed poorly due to the recession. The former benefitted from the fiscal stimulus program, and the later was unable to operate.
As and when the vaccine or the pandemic is brought more under control with new treatments or improved testing and contract tracing, it doesn’t seem unreasonable to assume the more COVID impacted sectors (travel, entertainment, the arts, casinos) will start to recover.
In this scenario, many believe value shares will have their day in the sun again. From historical precedent, the switch from growth to value shares can be painful if you are on the wrong side of the trade. Investors have witnessed the sharp moves in share prices for a short time in August.
It’s at this point, the debate around growth and value can become more challenging.
The odd thing though is we have been here before. Post the GFC it has been harder and harder to generate growth from traditional value sectors. Just look at the Australian Banks, none have recovered from the May 2015 highs and yet property prices have continued to march higher. Woodside is in the proverbial doldrums versus the pre-GFC top of $66, and even BHP is not back to its $45 peak, despite the record iron ore prices.
We should ask ourselves the question, is there more going on that belies the traditional trends?
The answer lays, I believe, as do people much smarter than me that we are in for a prolonged period of low-interest rates.
In this environment, the acceleration of the digitalised world can become more entrenched. For investors, it will mean more disruption for traditional businesses and the continued advances in technological innovation.
These are big statements and remain very charged in the investment community.
In simple words, big long-term secular cycles will supersede the short-term cycles, in the absence of an outbreak in inflation. Think the information age of digitalisation, the DATA era, electric vehicles, streaming services, eCommerce, neo-banks and any other disruptor that comes to mind. The notable names that slot into secular growth are Apple, Amazon, Facebook, Google, Netflix, Microsoft and most likely, Tesla as well as the newcomer Zoom.
There is also a school of thought that these types of companies that invest more in human capital rather than physical capital (think bricks and mortar, factories etc.) will continue to grow at a more rapid rate. Some experts refer to these companies as “weightless” or “capital-light”.
If this theory comes to pass, then investors will continue to continue to buy growth companies over the cheaper, value shares.
The counter side of the argument is any economic pickup will be accompanied by inflation, higher interest rates and the resurgence of the cyclical value shares.
Of course, none of us can predict the future, but at the very least, we can have a sounder understanding of how we are investing our savings, whether its indirectly through ETFs and managed funds; or directly in shares.
As always, we all need to do our homework. Buying a stock or an ETF because your friend likes it or you read it on twitter, is not a good recipe for success.
Losing money on a share investment is terrible, but losing money on a share because you didn’t understand the product or company is far more depressing. Know your company and why you own it, so at the very least when the share market sells off, you will have a better understanding of how to respond
This was written on Wednesday, August 19 and represents only the views of Danielle Ecuyer, Author of Shareplicity. The Author holds or has held some of the shares discussed in her SMSF. Please read the disclaimer.
DISCLAIMER – Shareplicity offers information that is only general in nature. It does not take into account your personal financial situation, needs or objectives. Nor does it take into account the financial needs of any specific person. You should consider your own personal financial situation and needs or seek financial advice before making any decisions based on this information.