Market Briefing (no.45) – 12th April 2022
Be smart about diversification
Between December and March, global markets – as represented by a major US stock market index – saw a significant double digit fall in this short period of time.
What caused this fall, and what, if anything should investors do?
Graph 2 shows two worldwide equity indices that measure global ‘Growth’ and ‘Value’ stocks.
This graph shows the significant change in what is known as ‘style rotation’, i.e. the change in relative performance from ‘Growth’ to ‘Value’ investing that we have recently witnessed.
This was a significant change, combined with a speed that many view as unprecedented.
So, what has been behind this shift in market sentiment and preference?
- the continuation of the covid pandemic;
- inflation and rising interest rates
Some of the firms who were pandemic ‘winners’ became ‘losers’ – and vice versa. As economies reopen, higher inflation and the expectation of higher interest rates has caused a reversal in growth stocks.
Most pandemic ‘winners’ were Growth stocks, resulting in their share price increasing. In the main, this was because of the restriction and shifting work and spending patterns caused by the pandemic. This meant that when the pandemic’s grip on economies receded, the ensuing reversal and normalisation in demand saw some share prices fall more than may have been the case in ‘normal’ markets. In essence, they had further to fall from their recent high levels.
So the question that could be asked is – Growth or Value equities: which are best for a portfolio? Aligning an investor’s portfolio with Growth or Value equities is a common investing approach, but few investors understand the key differences and characteristics between these categories. Also, is this the correct question in the first place? To help determine which may be best for a portfolio, the following is a summary of each and how they operate.
What are the main features of Value equities?
‘Value’ companies frequently show lower valuation metrics than those considered as ‘Growth’ equities. As the name suggests, ‘Value’ equities trade at valuations below what would be considered their true or fair value. They could be seen as the ‘January sales’ of investing; the item retains its intrinsic value, but is being sold for a lower price. That said, some stocks are ‘cheap’ for a reason and as such represent a relatively poor investment opportunity.
Value companies usually invest less in long-term opportunities and return more of their profits to shareholders, e.g. via dividends. Although dependent on industry type, they can also be more economically sensitive and potentially reliant on extensive debt financing.
When is the ‘best’ time to invest in Value equities?
Typically this is when economic growth is expanding, i.e. the early part of the market or economic cycle.
However, when economic growth slows down, Value equities can face what are called “headwinds”.
Such headwinds can cause a bear market – defined widely as when an equity market declines more than 20 per cent. Value equities can be excessively hit during this type of market as a result of their frequent reliance on debt financing. Banks tighten their lending criteria which investors then interpret as them being unable to pay their debt responsibilities.
This investor sentiment eventually becomes overly pessimistic with many Value companies in fact being able to withstand the economic slowdown as they can cut costs to reflect falling revenue in a
slowdown. This creates a gap between reality and expectations; this gap potentially propels Value equities to outperform when a new bull market begins.
What are the main features of Growth equities?
This investment philosophy generates growth returns that exceed the broader economy, which is why it’s called ‘Growth’. As you may likely expect, Growth equity features are the opposite to Value. They generally trade at higher valuation metrics, may have lower debt financing, if any, and are impacted less by negative economic conditions. They typically reinvest their profits for the future rather than paying out dividends, which leads to increased future profitability potential. The price paid for the companies is more reflective of anticipated future revenues, discounted to today. Thus, their valuations are sensitive to the discount rate used which is linked to interest rates. As interest rates rise so do the discount rates. A higher discount rate means that future revenues are worth less in today’s terms.
Keeping in mind that ‘past performance is no guide to future returns’, historically, the Growth philosophy outperforms Value when the economy is slowing down and is, or has, matured. This typically occurs later in an economic cycle. Growth equities can outperform for long periods of time before a bear market, and, because of their relatively low debt financing, they are potentially an attractive investment during an economic slowdown.
What effect do industrial sectors and geographical jurisdictions have on both philosophies?
Strict ‘rules’ regarding which philosophy applies to different industrial sectors would be impractical, however discretionary consumables, IT and communication services are generally Growth equities. Whereas financial, energy (including utilities) and healthcare are generally considered as Value equities.
Geographical jurisdiction is another area where definitive ‘rules’ would be unreasonable. For example, the US has most of the world’s large IT firms. As a result, US equity performance is hugely impacted by Growth equities. However, there are plenty of Value equities in the US as well. These tend to be more domestically focused in nature.
On the other hand, the UK has high exposure to the healthcare, financial and energy sectors and so UK equities’ performance is closely associated to Value equities. However, there are Growth equities in the UK as well.
Is Growth or Value better?
This is the wrong question. Neither Growth nor Value is inherently superior. There are appropriate times to hold more of one than the other. No one philosophy will remain superior in performance terms permanently.
What should this tell you?
Remembering that “past performance is no guide to future returns”, from an investment perspective, investors should have a balanced view towards investing philosophies such as Growth and Value.
Investors’ focus should be on ‘smart diversification’. This should include investing across different asset types, such as bonds as well as equities and across geographical jurisdictions, so they are not confined to one or two countries or regions. It should also involve investing across investment styles, that should include active management and index/passive investing. And finally, they should invest across different investment philosophies such as Growth and Value.
Although ‘smart diversification’ doesn’t guarantee performance, and does not eliminate risk completely, having a diversified portfolio across asset types, geographical jurisdictions, investment styles and philosophies can help investors to minimise their risks.
It is also important to remember that it is often the case that investors have a long-term investment time horizon. So, although ‘smart diversification’ does not guarantee against loss, it will likely help with the most important component of reaching long-range financial goals whilst minimising risk.
As we have said many times before, we will continue to monitor the current financial situation and keep you notified of any significant changes that are made. Please contact your Foster Denovo Partner if you wish to discuss your financial situation further.
This week in history …
- Financial Express Fundinfo