July 10, 2023
After an impressive Year 2022, value companies underperform again
By definition cheap, their valuations have become very attractive
To outperform, they will need the yield curve to steepen
The companies are mainly listed in Europe, in defensive sectors

CHARTS OF THE WEEK: "Performance of 'Value' versus 'Growth' equities since 1975"


"Value" and "Growth" are two styles of investing in stocks that tend to follow long cycles. Between 2007 and 2020, value stocks almost systematically underperformed (see Charts of the Week). On average, they generated 9.8% less each year than growth stocks. This has not always been the case, quite the contrary. Between 1975 and 2006, in 63% of cases the value approach outperformed the growth approach, generating 5.2% additional performance. If investors are once again interested in value stocks, it is partly because, since 2022, they have been trying to recover. Is this a false signal or the start of a new mega-trend? The value style consists of investing in companies whose fundamentals are sound but whose share price does not seem to reflect them. These so-called "cheap" stocks can belong to any sector, but they are mostly found among financials, utilities, pharmaceuticals, consumer staples (see Fig. 2), and even energy, heavy industry, chemicals and the media. To detect them, like Warren Buffett, the value investor uses ratios to compare companies with each other or with their own historical valuation: price to earnings, price to book value, price to sales, price to cash flow and dividend yield. The main challenge with this approach is to avoid companies that are at a discount because they destroy value, so-called 'value traps'.

Fig. 2 - Main "Value" sectors

▪ Financials: banks, insurances and financial services have recurring revenues that allow them to pay good dividends, a feature favoured by value investors.

▪ Utilities: companies are heavily regulated, with high entry barriers, resulting in predictable profits and high dividends.

▪ Healthcare: pharmaceuticals, medical care providers and equipment manufacturers have low cyclicality, delivering stable earnings and dividends.

▪ Energy: oil and gas companies have tangible assets and are regularly undervalued during periods of low energy prices.

▪ Consumer staples: producers of food, beverages, housewares, or clothes face constant demand and relatively unvarying profits.

In contrast, the growth style focuses on fast-growing companies that reinvest profits in the business. Their future intrinsic value will therefore be higher than their current intrinsic value. The IT, consumer discretionary and medical technology sectors are excellent examples (see Fig. 3).

Fig. 3 - Value vs Growth: sector breakdown

Fig. 4 - Value vs Growth: valuation ratios

To identify these stocks, investors look in particular at growth in earnings (historically and prospectively), as well as in sales, cash flow and the company's book value. Growth companies will therefore experience an expansion rate above the market average and high stock market multiples (see Fig. 4). On the other hand, their dividend payout ratio will be low, as they need to reinvest their profits in order to sustain their growth. For the investor, the main risk of the growth style is buying stocks that do not deliver results that meet market expectations.

The relative performance of value versus growth stocks is determined by the following key variables:

▪ The economic environment. In periods of business expansion, growth stocks tend to perform better, as they are expected to have higher earnings growth. By contrast, during slowdowns or recessions, value stocks are more resilient, due to their inherent undervaluation.

▪ Interest rates. Low borrowing costs are generally good for growth stocks, as they reduce the discount rate applied to future earnings, making them more valuable in today's terms. Conversely, rising interest rates favour value stocks, as they offer sufficiently high dividends to make bonds unattractive.

▪ Investor sentiment and risk appetite. When investors are optimistic and in a risk-on mode, growth stocks outperform. As long as expectations of high future earnings are attractive, high valuations are no longer an obstacle. On the other hand, when investors are wary, value stocks can generate better returns. Being part of more stable and mature sectors gives them a reassuring risk profile.

Fig. 5 - Asset allocation strategies as a function of the economic cycle

▪ Market trends and cycles. The pace of economic growth favours one style over another (see Fig. 5). During phases when the trend is accentuated (expansion and recession), value stocks tend to offer higher returns. On the other hand, in reversal phases (peak and recovery), growth stocks gain the upper hand.

▪ Corporate earnings growth. Strong earnings are good for growth stocks, as their higher price/earnings ratios are based on large future profits. Conversely, value stocks, which are often priced on the basis of lower expected earnings growth and a margin of safety, will look less attractive and underperform.

▪ The inflation rate. Rising prices favour value stocks that are able to pass on rising costs to consumers (such as the commodities sector) or benefit from rising interest rates (such as financial companies). Conversely, growth stocks suffer, as future earnings are worth less in today's dollars.

In the United States, value stocks are finding it harder to outperform growth stocks than elsewhere in the world. The reason is both simple and structural. Since the early 1990s, technology companies have been on a very buoyant trend, and the Americans have taken the lead: Microsoft, Google, Apple, Facebook, Amazon, Netflix, Tesla, Nvidia, etc. With the development of the internet, the roll-out of mobile phones, the digitalisation of the economy and, now, the rise of artificial intelligence, these companies have seen their share prices soar. Against this backdrop, it is easy to understand why, in the US more than anywhere else, value stocks are underperforming growth stocks. In the rest of the world, and particularly in Europe, the comparison is easier.

It is essentially for this reason that investors are seeking to arbitrage the performance of value against growth stocks in Europe. Value companies are cheap by nature but, at the time of writing, they are very cheap. The price/earnings ratio of global equities is relatively high given its history. However, when broken down (see Fig. 6), it appears that the price/earnings ratio of value stocks has remained low (12x), while it rose sharply for growth shares (30x).

Fig. 6 - Value vs Growth: valuation ratios

After a long period in the wilderness, what could trigger a comeback for value stocks? Kenneth Fisher, former star columnist for Forbes magazine's Portfolio Strategy column, founder and chairman of Fisher Investments, provides an excellent answer to this question. In the best-known of his eleven books, The Only Three Questions that Count, he describes how the yield curve predicts the performance of value and growth stocks relative to each other. The theory is simple and can be summed up in two sentences. After a period of inversion, when the yield curve steepens again, banks have found it so difficult to generate income that they only lend to good quality companies: value companies. Since they have better access to capital, it is easier for them to increase their profits and see their share prices outperform those of growth companies.

Figs. 7 & 8 - Value vs Growth: yield curve in the United States and Europe

The rationale is simple but powerful. Since 2009, Ken Fisher's theory has provided an almost perfect track record, with the exception of the Covid-19 pandemic shock for US stocks (see Fig. 7 and Fig. 8). Once again, when investors expect the Fed to cut interest rates and the yield curve to steepen, the value style will benefit from cyclical rotation to the detriment of the growth style. It's still early days, but it's only a matter of months. Thereafter, the upside potential will match the earnings momentum (see Fig. 9 and Fig. 10).

Fig. 9 & 10 - Value vs Growth: relative earnings growth in the US and Europe


Value stocks seem ready for a recovery. They need a trigger to start a cycle of outperformance relative to growth stocks: a recession or, better still, a steepening of the yield curve. Investors' love affair with growth stocks will eventually become less passionate and more realistic. They will look beyond the dynamics of the FAANGs and the development of artificial intelligence (AI). In Europe, where technology companies are less represented in the indices and valuations are more attractive, investors will have no hesitation in favouring value stocks. They are about to awaken the Warren Buffett in them.


Financial Research