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European equity outlook: the roaring twenties

24 January 2020

Why we need to talk about value versus growth (again)

In a series of articles at the start of a new decade, GAM Investments’ Niall Gallagher and Christopher Sellers discuss some of the considerations which are shaping their investment strategy in 2020 and beyond in the context of a positive overall outlook for the European equity asset class.

First, they revisit the ‘value’ versus ‘growth’ debate to examine whether there is a case for style rotation and ask whether there is a more instructive analytical framework available for investors to calibrate positioning.

Investors in developed market equities have made attractive returns by sticking with growth, more specifically quality, stocks over the last decade and ignoring the many false prophets preaching mean reversion toward value. This was a good call – we suggest – because much of the growth outperformance in 2010-2019 represented the deflation of the previous decade’s value bubble. We revisit the history of the value versus growth debate in more detail below.

But, as we head into a new decade, the picture seems more complicated. We are not necessarily expecting a paradigm shift of the sort recently predicted by Ray Dalio1. A change of leadership, however, is certainly plausible in subsequent innings of this bull market. Equally, in the event of a broader asset class correction, it is not inconceivable that non-traditional defensives might fare better, largely as a result of lower crowding. From the third quarter of 2019 onwards, market price action certainly seems to have been suggesting that the continued divergence of growth and value might no longer be a reliable source of outperformance for investors (if it ever was).

To pursue their desired returns from investing in equity in the next decade, we suggest that investors need a very clear view on factor movements, as well as their fundamental strategy.

We suggest there is now a more powerful case for saying that some areas of the value universe are indeed cheap (notably companies with more cyclical / volatile earnings growth), and that some areas of growth (quality, low volatility) are expensive. We discuss the importance of the volatility theme in our next article ‘Value, volatility and the prevalence of factor investing’, and suggest that low volatility growth has been disproportionately well rewarded in the era of quantitative easing.

We often hear claims that a significantly higher premium should be paid for the select group of companies able to achieve high ‘structural’, as opposed to ‘cyclical’, revenue and earnings growth in a deflationary world. We explore this debate in our third article ‘Value versus ‘value traps’, where we caution against too much of this sort of thinking. At the start of a new decade, we also examine whether there is a fundamental case for a reassessment of three major value sectors that have consistently underperformed in recent years.

The starting point

When the debate last raged between growth versus value stocks back in 2015, we deprecated the idea that there was an investment opportunity for astute investors to switch out of European growth stocks and into value stocks. We believed that the outperformance of growth stocks relative to value stocks in the eight years from 2007 to 2015 was simply a ‘normalisation’ of valuation and earnings power following substantial value outperformance from 2002 to 2007.

Chart 1: MSCI Europe value versus MSCI Europe growth

 
Source: Morgan Stanley, MSCI. 30/01/1975 – 30/08/2019. For illustrative purposes only

Chart 1 makes the point on the relative performance of value versus growth as investment styles over the long term; this clearly shows the major outperformance, and then underperformance, of value relative to growth over the period 2002 to 2015. Our view was that growth and value styles looked about in balance in 2015.

Something similar can be inferred from Chart 2 where, on a composite valuation metric, growth and value looked about in balance in 2015, with growth having being cheap relative to value earlier in the decade and very cheap relative to value in the mid-2000s.

Chart 2: European value versus European growth average valuation premium

 
Source: Morgan Stanley, MSCI. 31/01/1975 – 29/11/2019. For illustrative purposes only

But is value now cheap – and is growth now expensive?

That said, growth has continued significantly to outperform value since 2015. Chart 2 shows there is now a case to be made that value is cheap, or even very cheap, relative to growth, and vice versa growth expensive relative to value.

This could be because value is intrinsically cheap or because growth is intrinsically expensive, or perhaps some combination of the two. Chart 3 shows that for the market as a whole, and relative to the history of the last 30 years, European equity markets are valued at about median values – so they are neither cheap nor expensive in absolute terms. Earnings are also not stretched, being in aggregate still below the previous peak in 2007, quite a contrast to the US equity market, where earnings are very much higher than the peak of the previous cycle.

Chart 3: Price /earnings valuation of MSCI Europe

 
Source: Morgan Stanley, MSCI. 29/01/1988 – 31/10/2019. For illustrative purposes only

Chart 4 shows the valuation history of the MSCI Europe Growth and Value indices over a shorter timeframe and highlights quite how large a differential has opened up. At the same time, it is important to note that value earnings have thoroughly mean-reverted from their peak in 2006 (think energy and materials) and value index earnings upgrades have actually outperformed those of the growth index over the last two years. Therefore, it is logical (initially) to conclude that many value stocks and sectors are, indeed, now historically cheap and that many growth stocks and sectors might now be historically expensive.

Chart 4: MSCI Europe Growth P / E and MSCI Europe Value P / E

 
Source: Bloomberg, MSCI. As at 31/12/2019. For illustrative purposes only

But is there more to it than this?

There certainly are elements of value cheapness and there certainly are some expensive growth stocks, but selectivity is required. There also needs to be an acceptance that this is an overly simplified framework to explain what is going on. The increasing and profound influence of factor investing in all its forms is interacting with broader macroeconomic and geopolitical risks in ways that are often hard fully to understand. This, in turn, is contributing to crowding and valuation anomalies that can confound fundamental active investors, but also may offer attractive opportunities.

In our next article ‘Value, volatility and the prevalence of factor investing’, we will seek to move the debate beyond growth and value. We will examine the question of divergence in the market through the prism of factors to determine whether this can provide a clearer guide to the distortions which we observe. Some valuation anomalies seem driven by stocks’ volatility and cyclicality as well as their value characteristics.

And, in a further article ‘Value and value traps’, we will discuss some of the fundamental reasons which go some way to explain the historically high levels of valuation divergence we observe in the European equity market.

1Paradigm Shifts, Ray Dalio, www.economicprinciples.org

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. Reference to a security is not a recommendation to buy or sell that security.