The immediate prospects of any investment are as uncertain as those of any of the popular television series, Game of Thrones, characters but there is no doubt that, as their valuations rise, even stable businesses can become dangerous to own.
The battle continues to rage. It maybe not be as gory as Game of Thrones but the ongoing struggle between the forces of value and growth investing is every bit as full-blooded – and certainly nobody can be confident about what will happen next.
Also, while it may not feel like it at times, the fortunes of value and growth have been seesawing for a good deal longer than the Lannisters, Starks and the rest have been on our screens.
To bring you up to speed on the latest twists and turns (on the battle of the investment styles – you will find no Game of Thrones plot-spoilers here), following what has become known as its ‘lost decade’, value enjoyed a marked shift in its favour in 2016.
This was not to last, however, and value has surrendered much of its gains versus growth over the first half of this year.
Growth’s march northwards
Growth’s continued march northwards has been led by two distinct forces with little in common aside from a growing detachment between their valuations and history.
They are the information technology sector in the US (driven by the so-called ‘FANG’ stocks of Facebook, Amazon, Netflix and Google) and the consumer staples sectors in the UK and continental Europe (driven by the so-called ‘bond proxy’ businesses).
This year, the ‘valuation gap’ between these racy US tech companies and traditionally ‘sleep-easy’ bond proxies, and everything else has grown wider.
We are increasingly concerned about the two sectors as, in equity investment and over the long run, valuations will usually triumph over quality. Bluntly put, as their valuations rise, even stable businesses can become dangerous investments.
Comfort in underperformance
We would also argue there is some comfort to be found in value’s underperformance over the first half of 2017.
Across the globe, the majority of the performance gap between value and growth can be attributed to the higher price/earnings (P/E) multiples of growth stocks. In other words, investors have been willing to pay even more for those ‘growth’ companies than in the past.
Take, for example, the following chart, which shows both the earnings-per-share (EPS) growth and the price performance of the MSCI World Growth and MSCI World Value indices during the first six months of 2017.
As you can see, while the price of growth stocks has outstripped their higher EPS growth, the market has largely ignored the EPS growth of value stocks.
Earnings-per-share growth and price performance of MSCI World Growth and MSCI World Value
Source: Thomson Reuters Datastream, based on data from 31 December 2016 to 30 June 2017. Past performance is not a guide to future performance and may not be repeated.
Classic behavioural bias
An environment where P/E multiples are rapidly outstripping even the most bullish of forecasts from those who are paid to follow, dissect and analyse these two worrying sectors has echoes of the long inflation of the dotcom bubble in the late 1990s ahead of its rather more sudden bursting in 2000.
It is evidence of a classic behavioural bias where investors extrapolate current trends when forming future expectations. It goes without saying that we would rather avoid spells of investment underperformance.
There are, however, better and worse ways to underperform the market over short periods of time and, despite global profit margins nudging to all-time highs, the valuations of growth stocks are now pricing in ever-higher future earnings.
A lesson from history?
History suggests this cannot persist forever and, in the past, a dislocation in the market such as we are now seeing has been a precursor to value outperforming as expensive growth companies withdraw to lower valuations.
One line from Game of Thrones could serve as a useful warning for growth investors:
If you think this has a happy ending, you haven’t been paying attention.
The following chart highlights the extent of growth stocks’ absolute valuation on a ‘price-to-book’ basis. This is an analysis metric that compares a company’s share price with its ‘book value’ – essentially, its assets minus its liabilities – and, as you can see, it is now significantly higher than it was at the peak of the dotcom bubble in early 2000.
Price to tangible book of MSCI World Growth
Source: Schroders, Bloomberg. Past performance is not a guide to future performance and may not be repeated.
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