Growth stocks have continued a decade-long trend and massively outperformed value stocks for much of 2020, but in recent weeks performance has been more even. The change suggests many of the factors that propelled growth forward since the pandemic have been fully absorbed by the market. But is that enough to stage a changing of the guard for value investing?
This blog post reflects on what fueled the divergence between growth and value in recent months, what it will take to reverse value stocks’ fortunes, and why the recent economic downturn may turn out to be a positive change agent for some companies in value indices.
Behind Growth’s Outperformance: Low Inflation and Companies on the Right Side of Productivity
We believe two main factors benefited growth stocks coming out of the pandemic-induced economic slowdown. First, the areas of the economy that the pandemic hurt most tended to be lower-wage, lower productivity industries that provide person-to-person service. Examples include retail, transportation, airlines, hotel and restaurant industries. By and large, these are value stock categories. Energy stocks, which are another large component of value indices, were also punished as the economic slowdown dampened demand.
Companies in higher productivity areas such as technology were less affected by the pandemic. These businesses primarily fall in the growth category.
Expectations of an extended low inflation environment have also supported growth stocks. Growth stocks’ valuation is based largely on the string of earnings they will earn in the future. Low inflation means the value of those future earnings streams are worth more because they won’t be inflated away.
Meanwhile, low inflation is a headwind for a value company. These companies generally have more leverage than growth companies. If there’s low inflation, a dollar in the future maintains its value. Translation: value companies’ debt isn’t getting any cheaper for them to service. And low inflation suggests they can’t count on pricing power to raise revenue either.
Is Value Due for a Comeback?
The trends above had helped push growth stock valuations higher in recent months. At some point, markets were bound to reassess extreme valuations. That has happened recently, with the tech-heavy NASDAQ index briefly hitting correction territory last week.
The recent slump by growth stocks has put growth and value performance roughly in line with each other since the end of July. Many wonder if extreme valuations differences between growth and value stocks means value is now due for its own run of outperformance. For this to happen, we think the market will need more signs of economic improvement.
Value stocks are typically more economically sensitive than growth stocks, but that is even more true in the recent downturn. To a large extent, value stocks are associated with companies that primarily benefit when people are moving around and spending money. That just doesn’t happen when people are nervous about coming out of their home and congregating.
However, news about the virus has started to sound more encouraging. The number of new U.S. cases has been trending down. Offices are starting to reopen, with JPMorgan announcing last week it will call its traders back to the office. Once we see more states reopen and the economy begin to rebound, we wouldn’t be surprised to see value outperform growth.
How are we Investing?
At Dana, our strategies are core equity strategies. As we mentioned in a previous blog, we look for investments that have characteristics of both growth and value stocks. We are valuation-conscious, which leads to a value bias, but we don’t make directional calls in our portfolio with an intentional shift toward value or growth.
However, some of our strategies have started to take advantage of attractive valuations and invest in companies in the hotel, travel and restaurant industries who would benefit as the economy gradually reopens.
We are also finding opportunity in stocks that have a good “self-help” story. The one silver lining in the recent downturn is that it has forced management teams to re-evaluate costs and think hard about how they can run their business more efficiently. We believe some of these businesses are poised to come out of the downturn running leaner than ever and could see a substantial earnings boost with even a modest economic lift. We’ll continue to do our due diligence on these companies in the months ahead.