Nothing goes on forever in financial markets. For all the noise and industry fashions; whether it’s the importance of geographical weightings, economic statistics or portfolio risk measurement driven by index construction, they all come and go, reverting to the mean and overshooting in the other direction.
The one thing an investor can rely on is that the pendulum will always swing back. If only we could predict when the turn will happen it would be all so easy. It is not that simple of course and more money has been lost mistiming the tops and bottoms of different investment styles than ever was given up in the downturns. It is why sensible investors accept the steady plod of time in the market over the more exciting, but ultimately costly, attempt to time the market.
The pendulum swing currently exercising the minds of investors is between two predominant investment styles — Growth and Value.
Growth shares are those companies that can be expected to deliver rising profits regardless of what has been going on in the wider economy. They are often businesses selling products or services that we cannot or do not want to do without—toothpaste, smartphones and alcohol all spring to mind. Because sales and profits, and therefore dividends, are perceived to be reliable, investors are prepared to pay a high price for these kinds of shares and are particularly happy to do so when economic growth is poor. They also include the high-tech companies which have become known as the FAANGs, an acronym for Facebook, Amazon, Apple, Netflix and Google. Growth shares do well when growth is weak as has been the case for the last decade.
Value shares on the other hand are out of favour companies that are cyclical or facing structural challenges. They include companies that are challenged by ongoing technological change and the erosion of pricing power. The share prices of these companies are cheap against their own history and when compared with more modish growth stocks. Because these companies are so unpopular it does not take much of an improvement in the external environment for these kinds of shares to look oversold and attractive to contrarian investors. Value shares do well when the economic backdrop starts to improve or simply stops deteriorating.
The 10 years since the financial crisis have not been a good time for Value shares. The long, slow recovery since 2008/09 has seen investors gravitate towards consumer staples and technology shares that have been able to promise profit growth in this sluggish environment. Growth shares have become ever more expensive while value shares have become cheaper still and the valuation gap between the two has widened to an unprecedented level. Over the past couple of years that trend has been accentuated by the headwinds blowing through the global economy. The trade war and the Federal Reserve Bank of America’s desire to normalise monetary policy have provided the near perfect environment for growth investors.
Since the end of August, however, there has been a resurgence in value stocks which have picked up the performance baton as the economic backdrop has shown signs of improvement. Business surveys point to a bottoming out of the growth cycle. Company profits have turned out better than expected and look likely to improve further. Donald Trump looks like he is starting to prepare for next year’s election with a tactical retreat on the trade front and the Federal Reserve Bank of America has gifted investors three precautionary interest rate cuts.
This combination has been catnip to value investors. Banks, out of favour for much of the last decade, have benefited from a shift in bond yields that have made it easier for them to make a profit by borrowing cheaply and lending at higher rates. Industrials have been buoyed by hopes for another extension of the economic cycle.
If the current rotation from growth to value stocks is more than a flash in the pan, there are some important implications for investors. The first is that an improving outlook for value shares is good news for the whole market. History shows that the best periods for investors are those when value is outperforming growth.
The second is that if the change is for real, the pendulum is likely to swing for several years. Growth has been in favour for a decade, while value was the predominant style for nearly as long, after the bursting of the dotcom bubble in 2000. Investors tend not to hop quickly from one style to the other.
The third implication is that active managers, many of whom have struggled for many years to beat the market, could once again have their moment in the sun and start to fight back against the passive funds, that have swept all before them in recent years.
Even if the pendulum is starting to swing back towards value there is no need to panic. In an uncertain world, reliable earnings and profits will continue to be attractive to investors. The corporate failures in recent years, remind us that time is against the weak and benefits the resilient. The failures highlight the damage of debt.
In constructing an investment portfolio that will stand the test of time, a balance between value and growth investing looks sensible but, in the end, everything comes back to the primacy of return on capital employed. By focusing on businesses with sustainable high returns, investors will be rewarded regardless of whatever investment style is in favour.
It is perhaps appropriate to conclude this article with a comment on the current political scene which continues to dominate short term thinking. When it comes to specific political outcomes, whether they be Brexit, now twice delayed, the upcoming general election or the US presidential election in 2020, short term tactical decision making is likely to fail. Such events are unplayable and distracting for long term investors. Clarion endeavor to take account of, and protect against, all substantive risks to the Portfolio Funds. This requires an appreciation and understanding of multifarious political outcomes. However, we spend a much greater part of our time identifying and analysing Funds which should be able to perform well regardless of the wider political and macroeconomic backdrop.
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