James Klempster: Are we waiting for a value fightback?

The relative performance of ‘value' companies over ‘growth' companies has become a hot topic. The outperformance of growth companies has been extreme with a 4% per year outperformance of growth versus value since 2014. This has left valuations of many of the fastest-growing companies looking stretched. Value has made something of a fightback since September, but it is early days to call a revival. 

Since the global financial crisis, a number of factors - notably inherent caution and low interest rates - have conspired to push investors to seek out companies that offer very high and visible growth potential, for example, as a result of a secular tailwind or new disruptive technologies. Value stocks - those with cyclical earnings, or in less fashionable industries - have been left behind. 

The biggest question for investors is whether parameters such as low interest rates and caution have become permanent features. 

Companies with a platform as well-established as, say, Facebook are increasingly difficult to compete against

If they have not, it would be safe to assume that value stocks would mean revert and growth stocks would underperform. However, this is not assured. While we are always wary of saying ‘this time it is different' - it seldom is - there is an argument that certain growth stocks are now so powerful, and bond yields so low, that it has changed the way these companies should be valued and that high valuations are justified. 

Investors may remember this particular line of thought from the technology bubble. Companies should no longer be measured on revenues, for example, but on ‘eyeballs' or ‘clicks'. 

That said, this is not quite the same. Growth investors argue that there are certain trends that are now so powerful that companies with exposure can make super-normal profits far in excess of those expected by the market. Furthermore, many of these businesses are generating significant revenues, which was not the case during the dotcom bubble. 

These may be areas such as mobile internet, e-commerce, video-sharing or advanced medical devices. The opportunity for internet advertising or cloud-based services in China and India
is vast. 

Companies with a platform as well-established as, say, Facebook are increasingly difficult to compete against. All this suggests that the high valuations of certain growth companies can be justified. 

Equally, ‘new economy' companies have fewer intangible assets. Unlike, say, utilities, these companies do not have mountains of capital tied up in plant and machinery, which is inherently inflexible in its application. Instead, theirs is a completely different business model; these companies are not tied to a physical assets or a particular territory, which means their businesses are agile and their growth opportunity is truly global. 

In this context, metrics such as price-to-book value of assets are no longer a good indicator of value. While some value managers would argue that these companies look expensive on a price-to-book basis, in many cases this no longer appears to be an accurate reflection of their value. Hilton, for example, has seen its price-to-book ratio expand from below 1x to over 200x as it has sold its hotels and set up franchising arrangements. This has been good for its business but makes it appear expensive on the measure of price-to-book.

Equally, we should look at the role of sustainable investment in the value/growth debate. There are some old polluting companies who will need to fundamentally change their business models, at huge costs, or risk becoming obsolete: the car industry, for example. 

At the same time, as more capital is managed to sustainable goals, there are some companies that will struggle to attract investments. This means that traditional value investing, which assumes reversion to a mean, might need to adjust. 

That said, the stretch in valuations for growth stocks is now extreme. It would be logical to avoid ‘value' stocks if growth stocks had stronger fundamentals. In this case it would be possible to argue that value stocks were a value trap - a situation where the shares look superficially cheap but earnings continue to deteriorate. However, increasingly, this is not the case. If anything, earnings have been improving for many traditional ‘value' areas at the same time as prices have fallen; this should be the opposite of a value trap. Investors have also overlooked a deterioration in the fundamentals for some of the higher growth companies. 

There is also still a question over whether some ‘disruptive' growth companies can sustain their advantage. Even for the strongest growth companies, their earnings expansion is seldom linear. Netflix, for example, has disrupted traditional media, but at some point traditional media will fight back. If it manages to do so successfully, it will make those higher valuations look harder to justify. 

September saw a significant rally for value assets, prompting many to conclude that the long winter for value is finally at an end. We would argue that there is value in value, as they say, but old-style value companies may not re-emerge. Investors need to be careful in the metrics they use to measure value in a changing world. Equally, we would say the market can support higher valuations for genuine growth companies with network advantages in areas of structural change.

However, valuation disparities are extreme and in some cases no longer reflect the reality of the underlying companies. 

We believe investors need to be careful at both ends of the spectrum, neither overpaying for growth companies that are not delivering on earnings, or value companies that are in structurally challenged areas or struggle on ESG measures. 

Timing the rotation between styles is notoriously difficult to do and, as a result, we advocate keeping an exposure to both value and growth in diversified portfolios. 

James Klempster, Director of Investment Management, Momentum Global Investment Management

This article appeared in the December issue of Professional Adviser's sister title Multi-Asset Review. To make sure you receive your own copy of the next issue, please do register your interest here

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