Following more than a decade of being out of favor, value investing gained significant ground in 2022. However, in recent years, the lines have blurred between value and growth, calling into question the traditional style classifications of various issuers and sectors.
While value and growth investing remain important investment approaches for investors to express their views, investors need to be aware of the idiosyncrasies of style market-cap-weighted index construction, and the ways market-cap-weighted indices may not comply with the expected characteristics of value or growth. We believe that it may be preferable to use active approaches to obtain pure or more-efficient exposures to value and growth.
The market has long-held views of what constitutes a value stock versus a growth stock. Post-Global Financial Crisis, the market doubled down on these views and the distinction became more polarized. Value became increasingly synonymous with more homogeneous, cyclical industries, while growth became more connected with faster-growing, more-defensive industries levered to positive secular change and disruption.
However, market-cap-weighted value and growth indices told a different story. Figure 1 shows that over the last decade, the MSCI USA Value Index has seen an increase in diversity of sectors (by market-cap weight). The value index has experienced a rise in market-cap weight invested in health care, information technology, and consumer staples — sectors that have traditionally been more synonymous with growth investing. Growth indices, by this same market-cap-weighted measure, have seen an increase in homogeneity (Figure 1).
The sectoral shifts in Figure 1 is also in line with the Herfindahl-Hirschman index (HHI) scores over time, calculated based on sectoral weight, as shown in Figure 2. The HHI is a common measure of market concentration and is often used to measure market competitiveness. We adopt the concept to measure the degree of sectoral concentration within indices. The higher the HHI score, the more concentrated or homogeneous.
There are several reasons for the changes in sector concentration described above:
Given these changes in sector concentration, a passive approach with market-cap weighting may result in a portfolio with a different complexion than pure value or growth, as traditionally defined.
The composition of both value and growth indices is markedly different from purer factor-based approaches. This is worth noting because, arguably, these quantitative approaches allow investors to build pure value and growth indices that are actively rebalanced. The universe of stocks can be stratified into value and growth styles using single value or growth attributes. Portfolios or indices are then constructed using the highest-scoring value or growth names (e.g., top quintile) based on equal-weighting or a value-weighted approach.
A striking example of the differences between the index- and factor-based approaches is the market-cap weight of financials under each construction. Figure 3 displays the sector composition of the top quintile of the Russell 1000 Index based on the book value-to-market (B/M) ratio (a factor approach). This analysis shows that the top quintile by B/M (highest-value quintile) has a growing concentration in financials attributable in part to the declining profitability in the sector. In general, the top quintile has become more concentrated in cyclical industries (financials, energy) over the past two decades, with financials alone accounting for over half the weight. The composition of this quintile is quite different from that of the MSCI USA Value Index illustrated in Figure 1.
Figure 3 also illustrates another knock-on effect of index construction design. In this case, the top quintile will have a higher interest-rate sensitivity versus the market-cap-weighted value index. This factor portfolio also shows greater interest rate sensitivity compared to pre-GFC, when there was more sectoral diversity in the top B/M portfolio, and when defensive sectors such as utilities accounted for about a quarter of the weight.
Despite the aforementioned changes in index concentration, value and growth can still help investors meet their goals to diversify and take advantage of opportunities to invest in companies with sustainable growth. We point to several trends punctuating the relevance of style investing.
In the ongoing race between investment styles, growth won out in terms of both investor interest and return during the period between the GFC and the COVID-19 pandemic. A number of factors were behind this decade horribilis where value found itself on the wrong side of many wagers. The decline in inflation and interest rates; the growth of ecommerce, social media, and the platform economy; regulatory developments in the financial services industry; and finally COVID were all negative factors for value. However, in markets, the pendulum cannot swing in one direction indefinitely, and we saw a significant correction post-COVID as investors revised valuations on the basis of higher discount rates and relative valuations that had stretched to historic extremes.
As a set of investing principles, value investing remains as relevant as ever. A focus on return on capital incorporating both earnings growth and the capital required to fund that growth (what we refer to as “earnings power”) with intrinsic value as the bedrock for any investment decision and a margin of safety in valuation appears to us to be a sound approach to stock picking. Different macro regimes (e.g., the inflation backdrop) or market regimes (e.g. excessive optimism, excessive pessimism) are likely to periodically favor the growth style over the value style and vice versa, but the nature of markets is that the pendulum tends to swing back over time (Figure 4).
The excessive optimism that dominated the past decades of investing has created a market with wide valuation spreads, indicating greater mispricing opportunities for value investors to exploit. Furthermore, the potential shift in the interest-rate regime and demographics could materially impact the value creation opportunities for firms. There will be winners and losers as the world transitions to a new normal. Active value investors should have greater opportunities to capitalize on mispricing from market underreaction to the gradual shift in macro fundamentals.
Despite weakness post-COVID as the market turned more defensive in 2022, we have seen growth regain momentum, and it remains an important tool for investors seeking to purchase companies with strong expected earnings growth.
Importantly, we espouse this point made by Warren Buffett in 1992: Growth and value “are joined at the hip: Growth is always a component in the computation of value.” Many investors would believe the market prices in the growth prospects of a company, but sustainable earnings growth compounded over time creates enormous value that is often not reflected in a stock’s price.
Figure 5 shows the justified valuation premium today for a hypothetical stock that will grow earnings at twice the rate of the market for different time periods (shown on the x-axis), after which its earnings growth reverts to market levels. In the left-hand bar, the growth period is maintained for three years, but even at this relatively short duration, a 15% valuation premium would be justified. As growth compounds over longer periods, earnings increase exponentially and so does the justified premium. So, a company that can compound a high growth rate for 10 years would be worth a 90% market premium today, and for 20 years of superior growth, the justified premium jumps to 289%. Investors buying this hypothetical company at something less than the justified premium are buying growth at a reasonable price. If investors focus only on the steep valuation without considering the coming years of compounding growth, they are missing the real story.
The power of compounding growth is often significantly underestimated. The longer a company can sustain a superior growth rate beyond the forecast horizon of the typical investor, the more undervalued that company is likely to be relative to its future growth. This creates a “growth margin of safety.”
Within shorter time horizons, transient factors, such as changes in multiples or margins, can drive stock returns. Over the long term, however, outperformance comes from compounding growth. As the Boston Consulting Group (BCG) concluded in a study, “revenue growth is the single most important driver of value creation for top performers over the long term.” 2 In its analysis, BCG showed that revenue growth accounts for 74% of total shareholder return (TSR) for top-quartile performers over a 10-year horizon, versus only 29% of TSR over one year. In other words, growth becomes ever more important as the time horizon extends.
The weights of different sectors on the value-growth continuum have evolved significantly in recent years due to a wide range of factors, such as rate, regulatory, and industry trends. Our outlook predictsfurther changes to the traditional thinking around value or growth stocks. Specifically, companies and individual securities that have usually been associated with one style may move into another, as micro and macro factors continue to impact the valuations of global firms. We consider several drivers of sector valuations in coming years.
With inflation likely to persist above the 2% level, interest rates could remain higher, suggesting a rise in the discount rate used to discount the value of free cash flow (FCF) forecasts which can negatively impact the value of long-duration assets typical of growth companies. Although investors will need to use a higher discount rate to value cash flows, we believe that companies with strong moat and structural growth drivers can mitigate the decrease in valuation. For example, engineering company Applied Materials, a tech industry leader and key supplier in the semi-cap equipment industry, will benefit from exponential growth in demand for semiconductors, driven by big data, AI, the Internet of Things, and cloud computing. Companies that have strong market positions will also have pricing power that gives them the ability to pass on, rather than absorb, higher inflation and can increase their top line to account for the higher discount rate. Pricing power comes from strong market positions, which can be maintained through supply cost advantages, favorable competitive dynamics, limited product substitutes in the marketplace, and high barriers to entry (e.g., via proprietary technologies, scale, and brand equity, among others). Not all companies are negatively impacted by rising rates. The financials sector benefits from higher rates due to the effects on net interest margins and company profitability.
Another big driver impacting sector valuations is technology and innovation. In the past, technology company pricing was considered cyclical, but we see these cycles becoming more muted, and the tendency is now toward an upward-sloping price curve. We expect further declines in the cyclicality of the technology sector going forward.
The reason is that the importance of technology to Wall Street, Main Street, and beyond is set to only increase. As we make sweeping changes to the ways we live and work, and we train even younger children to learn and interact using technology, new trends emerge that will underpin sustainable growth in tech — and in other sectors that benefit from a tech-heavy world.
At the same time, we expect continued adoption of the digital transformation theme, particularly through artificial intelligence will increase data center utilization, which will drive corporate investment in the modernization and digitalization of their operations. Technology today enables record levels of digital functionality, powered by massive amounts of silicon and computing power and facilitated by newly released software. Given the considerable levels of tech spend planned by companies,3 we remain confident in the long-term durability of these secular growth themes.
Net zero by 2050 requires the development and scaling of a significant number of new technologies, products, and services including alternative-energy-generation infrastructure, an alternative transport apparatus, new agricultural and manufacturing techniques, and novel carbon removal methods. Climate transition investment surpassed $750 billion in 2021, equivalent to the GDP of Sweden, and the pace of investment will scale up rapidly from here. This has crucial implications for both value and growth investing. The weighty capex burden associated with climate change, as well as green financing, is an important opportunity for banks — especially for European banks, which are currently challenged in finding loan growth opportunities. Furthermore, new market mechanisms, such as large-scale carbon credit markets, are expected to emerge. The resulting lift in spending could provide some upward pressure on inflation in the short term as it spurs increased activity and heightened demand of certain resources. However, over the long term, this targeted spending could lower the costs of resources such as energy and greatly boost productivity for certain sectors.
A fundamental understanding of company quality and valuation is required to take advantage of short-term market dislocations and long-term market regime changes. For example, certain companies may be able to build scale in areas where they have obtained a pricing or other operational edge, which in turn helps reinforce their economic moats.
One key to achieving alpha is to differentiate between stocks that have strong barriers to entry and thoughtful management teams and those that are over-earning due to temporary market conditions. Prowess in innovation provides a competitive advantage for companies — an advantage that can foster sustainable growth.
For investors wishing to implement value or growth strategies, some value and growth indices have seen significant changes and, as discussed earlier, are markedly different from purer factor-based approaches. It is important for market participants to understand that these variations exist, and to look beyond the surface-level definitions and investor expectations for value and growth. Importantly, our outlook is for further changes to the traditional thinking around value or growth stocks; specifically, companies and individual securities that have usually been associated with one style may move into another, as micro and macro factors continue to impact the valuations of global firms.
Already, in a case of such style shift, Microsoft and Amazon were added into the value index during the last S&P index rebalance, which has likely contributed to a drastic change in the relative valuation of the S&P value and growth indices. Figure 6 shows that the relative valuation is converging abruptly toward zero.
For active portfolios, we refer to traditional fundamental management, but we also extend our definition of active to include smart beta and active quantitative approaches. In our view, these approaches that combine value and quality or growth and quality to make investment decisions may be preferable given the nuances related to the construction of style indices, among other reasons.
An allocation to value using an active manager can allow investors to adapt to these developments. The blurriness of the line between growth and value has created an environment ripe for active stock picking. An active approach can focus on quality issuers with sustainable growth, while a passive approach may lead to implicit sector bets and shifts away from the perceived characteristics of a value or growth portfolio.
Across both value and growth, active managers can find opportunities by identifying quality companies, understanding pricing power, anticipating the implications of secular shifts, and taking advantage of short-term market dislocations. Investors can use an active value or growth approach to avoid looking too narrowly at investment possibilities and drawing simplified conclusions about sectors or individual securities.