26 October 2020
Following a period of significant change, GAM Investments’ Niall Gallagher and Christopher Sellers revisit the growth versus value debate in the context of the European equity asset class.
Almost a year ago, we wrote a paper considering whether there was a deep imbalance in the European equity market between ‘growth’ stocks and ‘value’ stocks. This was in response to questions from clients who were struggling with the same issue. In our answers back then we rejected the simple narrative of growth versus value and broadened the discussion to consider a multitude of ‘factor risks’, of which growth and value are only two among many. We concluded that while we struggle with growth versus value as an analytical framework for studying stock markets, there were anomalies in the market that we could identify:
- We found ‘low volatility’ stocks to be valued at a historically high valuation and considered many low volatility stocks to be particularly expensive. We attributed that partly to a historically low risk-free rate.
- We found cyclical, but otherwise high quality, stocks to be somewhat cheap and lower quality cyclical stocks to be very cheap but with a high level of selectivity required when considering individual ‘cyclical’ stocks.
- We pointed out that many stocks classified as value stocks were in fact businesses facing significant structural challenges from secular trends such as shifts in global consumption (the rise of the Asian middle class), technological change and disruption and policy changes to facilitate decarbonisation across a whole range of activities. Consequently, we pointed out that these businesses might not turn out to be cheap / good value in the long run.
A lot has changed in the past year and it is worth reconsidering some of these issues to see if our thoughts and conclusions might have, or should have, changed.
An update on factor risks
Charts 1 & 2 show price and valuation charts for the MSCI Europe Value versus MSCI Europe Growth indices. The continued divergence between growth and value indices is very striking, with another year of stark underperformance of value and a further widening of average valuations between these two styles; indeed the divergence is now at the highest level since the price series began 45 years ago.
Charts 1 & 2: MSCI Europe Value versus MSCI Europe Growth
Broadening the analysis to consider other factor risks shows a continued divergence in valuation / performance, as we highlighted a year ago, but now at even more extreme levels. The momentum and (low) volatility factor risks are trading at very high valuations versus history while the quality factor (a hybrid factor combining growth and low volatility) is at the highest valuation it has been in the 28 years of the time series; the opposite is true of the value factor, which is trading at its lowest valuation in the last 28 years.
Chart 3: Valuation percentile versus history for different factor risks
Correlations between momentum and other factors – sometimes considered a proxy for ‘crowding’ – illustrate that correlations between the momentum factor and the growth factor, the momentum factor and the low volatility factor and the momentum factor and the (hybrid) quality factor are all at very high levels, potentially suggesting a level of crowding. The correlation between the momentum factor and the value factor is at low levels potentially suggesting the opposite. Not only is there significant performance and valuation divergence between different factors, but this might also be reflected in the positioning of different investor types.
Chart 4: Correlation between momentum factor and other factors
It is all very well suggesting that there are / might be anomalies in the market, but are there good reasons for why these anomalies have occurred and what of the future – is there any reason to suggest these anomalies may continue or unwind?
The events of past 10 months provide good reasons why many sectors and stocks have performed as they have and potentially why some styles and factor risks have performed so much better than others given the make-up of such styles and factors:
- Restrictions on activities have impacted certain sectors, such as aviation and industrial businesses that support aviation; ‘lockdowns’ and consumer caution have damaged physical retail, hospitality and ‘experiences’; and, prospects for more permanent changes in working patterns have implications for property and business / support services located in business districts.
- Businesses with digital direct to consumer models have benefitted significantly from changes in behaviour, particularly in cases where they are also not in physical channels; software and platform businesses have benefitted from changing working and consumer patterns; and, payment businesses have benefitted from ‘distaste’ for physical cash.
- The continuation of zero / negative interest rates and suggestions from central banks that this may continue for several years have flattened yield curves making it very difficult for banks to generate decent net interest margins and a return on equity above the cost of equity; most banks in Europe are earning very low returns at present.
- Reduced mobility and falls in global economic activity have reduced the demand for oil, thereby reducing its price and the cash flows of oil extracting companies.
It seems somewhat obvious to suggest that future market style and factor patterns depend on what happens next, but policymaker reactions to Covid-19 and its perceived health risks and the competence of their execution are heavily distorting economic activity not only between industries but between countries in a way that is highly unusual. Approaching the northern hemisphere winter and gauging (anecdotally) the level of hysteria and catastrophising by public health advisors, amplified, in our view, by an excitable broadcast media and combined with policymaker panic, ineptitude and the need to be seen to be doing something, suggests we may not see a change in sector and stock patterns for the next few months. That is to say, many of the distortions of the last nine months will remain and this will influence patterns within stock markets.
Looking to the longer term, we can identify a number of structural trends that will be highly influential in driving patterns of demand and these will create tailwinds or headwinds for companies based on their activities:
- The shift in consumption growth from developed markets to emerging markets and in particular to Asia ex-Japan. Over the next decade as many as 900 million new consumers in Asia will reach middle income status – defined as an after tax income of USD 1,000 per month – implying that Asia will contain two thirds of the world’s middle class consumers by 2030. This has dramatic implications for a whole range of consumer, healthcare and industrial businesses; those exposed to this trend through leading presences in Asian markets will benefit while those without strong presences in Asia markets will experience far lower growth.
- The shift in commerce from the physical, offline world to the online, e-commerce world. This trend has been in effect since the commercialisation of the internet twenty years ago and has received a significant fillip over the last nine months, as consumers have been unable or unwilling to visit physical outlets. Those businesses with strong direct to consumer e-commerce capabilities will prosper while those who have struggled to digitise their businesses, create single ‘inventory views’ and a genuine omni-channel presence will suffer and may eventually die. The opportunity to prosper from this secular trend is not only open to e-commerce ‘pure-plays’ but also to existing, legacy businesses that have been early and effective in embracing digital technology and working to stitch together online and offline channel infrastructure.
- The shift in payments from cash towards payment networks. This trend will not only benefit from the growth in e-commerce but also increasing consumer acceptance of card payments, facilitated by integration into smartphones. There is a potential threat to many banks if payment technology companies successfully make the leap into card / virtual card issuance ‘closing the payment loop’ and controlling the entire payment cycle.
- Digital change in business processes. This secular trend covers a wide multitude of aspects of consumer and business practices and includes things such as the growth in cloud computing, the connection of devices and machinery (Internet of Things, Industry 4.0), automation, growth in e-commerce etc. Those businesses and industries that do not adapt or cannot adapt to changing business processes will suffer, while technology-driven disruption allows for wider than normal market share shifts.
- Decarbonisation and the greening agenda. The need to decarbonise is now widely accepted so as to keep global temperature change below 1.5c and many countries have adopted a net zero carbon emission target by the year 2050, or 2060 in the case of China. It is hard to underestimate how significant the policy changes resulting from binding environmental commitments will be; simply put, whole industries may disappear and others will be completely transformed.
Value and European equities in context
We think select European equities are well positioned towards these near-term challenges and longer-term structural changes. As shown by Chart 5, geographically Europe now only accounts for about 45% of the revenues of European equities with emerging markets and increasingly Asia ex-Japan accounting for an ever larger share. Exposure to faster growing regions will be a key benefit to those select companies so-exposed.
Chart 5: Regional breakdown of European equity revenues by source
Returning to the question of value versus growth, it is not clear when all trends are considered that ‘value’ in aggregate will see a significant medium-term revival. Figure 1 illustrates stark sector differences in the make-up of value and growth indices / styles and we think many of the value industries will struggle from a fundamental perspective:
- The banking sector will struggle to generate an adequate return on equity with interest rates at zero and flat yield curves
- Oil stocks have to contend with the short-term impact of low oil prices and the longer-term issue of decarbonisation
- Autos have to navigate a profound transformation to electric, or fuel cell powered vehicles
- Telecom services in Europe are over-supplied and deflationary
- Utilities are potentially more interesting given the transformational potential of those companies that adapt to ‘green generation’.
There almost certainly will be individual stocks within these sectors that will find a path to higher prosperity and these sectors do not account for the totality of the value style, but great selectivity will be required in picking stocks on value criteria alone.
Figure 1: Selected weight of sectors in MSCI Europe Value and Growth indices
Where could we be wrong?
The performance of growth versus value styles look very stretched in a historical context and headline valuations are characterised by a high level of divergence; at times such as these style rotations can occur, they can be rapid and often brutal. Such rotations are also very hard to predict / time in advance, although it is often easy to apply an “I told you so” narrative post-fact.
On a more fundamental basis, a significant reflation that not only boosted real GDP but led to higher inflation and the prospect of higher interest rates could witness a more profound style shift for at least a time. The banking sector in particular would likely see large benefits from rising interest rates with a jump in return on equity and potential ‘re-ratings’ possible; lower quality cyclical sectors and automotive stocks would also benefit from a significant reflation; and, a rise in economic activity that drove oil demand higher and oil prices higher would benefit the energy sector. Is this likely? We think not in the immediate future, but the high level of fiscal stimulus needs monitoring, as do changes in central bank attitudes to inflation and the very large amount of cash sitting on customer balance sheets.
As always, accurate stock picking and diligent attention to factor risk concentration will be the key to success.
Source: GAM unless otherwise stated. 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 the manager 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. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. October 2020