The growth versus value offset
Many of today’s younger fund managers – for example those who started their careers in 2007 or later – have only known an environment in which growth equities have outperformed value equities. Indeed, many industry discussions at conferences we attend discuss the view that growth is the only way forward, particularly in the United States. Many analysts in particular are unable to fathom why anyone would adopt a value bias, in any circumstance!
However, this has been borne out by recent results. Since 30 September 2007, the MSCI World Growth Index has returned 156.4%, whilst the MSCI World Value Index has returned 104.0%. This difference is even more pronounced in the United States, with US growth outperforming US value by 80% over the past decade. Ten years of loose monetary policy has consistently supported long duration growth assets – large-cap consumer staples and healthcare companies for example – whilst the well-known FANG style stocks (Facebook, Amazon, Netflix and Google) have also prospered.
As a result, growth as a style dominates US and global equity portfolios. Using Morningstar data for funds included in the IA North America and IA Global sectors, you can see in the chart below that just 28% of assets in these sectors are invested in value stocks.
Source: Morningstar Direct, latest available data to 30/09/2017. IA North America and IA Global sector constituents. Value, growth and core exposure calculated by using fund size and Morningstar equity style breakdown per fund.
What does history tell us?
What many investors do not realise, is that over the long-term, value stocks have significantly outperformed growth stocks. It has only been during periods of sharply falling interest rates – such as the last decade for instance – that growth has been the winner. This can be shown by the relative performance of the MSCI growth and value indices since their inception in 1975, as well as since 1927 using data from the Nobel Prize winning economists Eugene Fama and Kenneth French. In addition, the data shows that in decades where 10 year US treasury yields were rising, stable, or only slightly falling, value outperformed growth.
Source: Morningstar Direct, as at 30/09/2017. MSCI World Value Index relative to the MSCI World Growth Index, in US dollars. Fama-French Large Value Index and Fama-French Large Growth Index performance also in US dollars. Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested.
The global underweight to value, combined with growth’s decade-long dominance, provides us with an opportunity to gain exposure to undervalued businesses, an approach that has been proven to outperform over the long-term. This outperformance has been even stronger in environments when rates are rising. Globally, economic growth continues to be strong and central banks are beginning to normalise monetary policy, led by the US, where interest rates now stand at 1.25%. Last month, Bank of England (BoE) Governor Mark Carney suggested that rates will rise shortly, which contributed to a rise in yields across developed markets. We believe this environment of modestly rising yields will continue, and will be supportive of value investing.
For example, US banks are trading on a price-to-book (P/B) ratio of just 1.5x, despite an attractive earnings outlook. Furthermore, banks are able to generate higher profits when interest rates rise, as higher rates equal a greater net interest margin (NIM). In contrast, the S&P is currently trading at a P/B of 3x, whilst US healthcare companies are currently valued at 4x P/B and 26x trailing price-to-earnings (P/E). This is despite the fact that their valuations will inevitably come under pressure as their long-term cashflows will be discounted at a higher rate. Therefore, we believe the market’s fixation with growth will soon come to an end. Therefore, we have maintained our overweights in value sectors such as financials, materials and industrials, as well as maintaining a diversified exposure to other parts of the market.
Our investment approach
At Canada Life Investments, we adopt a flexible, macro-focused approach to global equity market investing. Therefore, the CF Canlife North American Fund and CF Canlife Global Equity Fund, for example have neither a constant growth nor value style, although we do typically maintain some form of value or growth-at-a-reasonable-price (GARP) bias. Macro factors play a very important role in the Fund’s sector allocation and stock selection process. Our favoured indicators include the Citigroup Economic Surprise Index (CESI) and various Purchasing Managers’ Indices (PMIs). We believe the CESI helps us to forecast as to whether any particular economy will surprise on the upside or the downside in the coming months, whilst the PMIs highlight recent expansion or contraction. Therefore, by being able to position our funds with a growth or value bias ahead of the market, we believe we can capture significant upside. This has proved to be significantly beneficial to the funds’ long-term performance, despite seeing some short-term periods where these early moves have held back total return numbers.
This investment approach means we often adopt a contrarian position in the face of market consensus. Given the dominance of growth investing over the last decade, we have therefore more often than not been biased towards value during the last ten years. Most recently, for example, we adopted a significant value slant in July as the CESI suggested that consensus views were becoming bearish, bond yields began creeping up on no news and we had not seen the level of underperformance we expected from the financials sector. This positioning has taken a few months to come to fruition, but value has started to outperform more recently.
We would also point to a value bias working very well in the second half of 2016. We were correctly positioned for this move, with big overweights in sectors such as financials, industrials and materials. This proved to be a significant boost to performance, with both the CF Canlife North American Fund and CF Canlife Global Equity Fund, ahead of the IA North America sector and MSCI North America Index and IA Global sector and MSCI World Index respectively. Prior to 2016, the last time value outperformed growth in the US was remarkably in 2008. We also performed relatively strongly in this environment, with both funds protecting capital on the downside.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
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