Equity Outlook  |  Q3 2019

Mind the valuation gap

Shep Perkins, CFA, Chief Investment Officer, Equities

Mind the valuation gap

Growth versus value — it's a frequently discussed and debated topic for equity investors. History has shown us that both styles alternate in leading the market, and neither wins indefinitely. But that may be little comfort to value investors over the past 10 years. For most of the past decade, growth has outperformed, and it has been most pronounced over the past five years, when growth has trounced value in both U.S. and international markets.

Cheap stocks have never been cheaper

Today, the valuation spread — the difference between the most expensive and the cheapest stocks — is at one of its widest points in history. The highest price/earnings multiples in today's market, which belong almost exclusively to growth stocks, are extremely elevated relative to the market's lowest P/Es, the bulk of which are in the value universe.

Why don't investors want value?

Since 2014, despite equity market advances, there has been a lingering cloud of concern about the pace and sustainability of global economic growth. The persistent fear that we are in the late innings of the economic cycle has done nothing to boost the popularity of value stocks. Economically sensitive sectors, such as financials and energy, make up a significant portion of value indexes. GDP growth matters to these businesses, and investors do not want to own them at the start of a downturn, as their earnings are viewed as vulnerable.

At the same time, many growth companies today appear to offer the benefit of durability. Investors believe their products and services are likely to remain in demand regardless of overall economic conditions. Many of today's leading growth companies are developing faster, cheaper — and groundbreaking — offerings that can be adopted globally. They are generating attractive returns on invested capital with higher margins and much lower capital intensity than many traditional businesses.

Obsolescence: A risk for all businesses, old and new

Enormous strides in innovation and technology have made obsolescence risk a key consideration for today's equity investors. Traditional businesses are under great stress. Television broadcasters, rural telecom providers, retailers, legacy software, advertising agencies, and many other industries face new forms of intense competition. It has been brought on by the advent of mass digitization and the global, low-cost reach of the internet. While many businesses will meet, and even overcome, these challenges with innovations of their own, the threat of obsolescence has been yet another headwind for value investors.

This threat is certainly not limited to value stocks or older businesses. It is a risk even within the narrow band of large-cap technology stocks that have dominated the market in recent years. These companies must continually work to create and sustain moats and maintain their competitive advantage, recognizing that a new and better version of themselves could emerge at any time. Among the many examples is Yahoo!, an Internet pioneer and one of the most popular search engines in the late 1990s and early 2000s. It was, of course, eclipsed by Google, which was launched later than Yahoo! but offered innovative features that led to its market share dominance today.

"The threat of obsolescence has been yet another headwind for value investors."

Time for new market leadership?

What could bring about a shift in the dominance of growth stock performance? A jump in inflation could be a catalyst. Inflationary pressure could force the currently dovish Federal Reserve to hike rates. As a result, we may see investors less willing to pay the steep price-to-earnings multiples that growth stocks command in today's low-interest-rate environment. A recession — or more specifically, the aftermath of one — could also revive value stocks. Typically, value stocks outperform in a recovering economy, especially when their earnings are depressed but are starting to recover. The recession itself would be painful for both styles, but growth stocks are likely to take a harder hit, as their elevated P/Es have the farthest to compress.

Next: Durable themes with room to grow


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