Late in 2020, one of our senior analysts wrote:
“I hear suggestions that a rally by value investments is imminent. I disagree. I believe that the opportunity to uncover and invest in great growth businesses is as strong as ever.”
Hubris? Over-confidence? The perspective of someone who has only ever invested in a super-low interest rate environment? What we can say for sure is that shortly after this was written, we saw a big rally in value against growth. The long, slow outperformance of growth that had been evident since mid-2007, and that had exploded upwards in 2020, reversed significantly. Growth, as defined by MSCI indices, underperformed value by 19% in the 18 months to end July 2022. Those at the high growth end of the spectrum saw considerably worse declines in that 18-month period.
Was this foreseeable? Some would argue that it was, as inflation was taking hold even before the Russian invasion of Ukraine. The standard policy response to higher inflation is higher interest rates, which in conventional wisdom reduces the present value of the future profits of companies, raises the cost of borrowing for those who are leveraged and makes it harder for early-stage companies to raise finance. So, markets have reacted pretty much as we would have expected, with the magnitude of the growth correction most severe for those companies with the most future-dependent profitability.
What are advisors and their clients to make of this? That growth will only recover when markets start to anticipate lower inflation and lower interest rates? To some extent this is probably true, and we may have seen the beginnings of it as recession looms over further interest rate increases. But here’s the thing— we don’t think any of this matters very much.
All growth is not equal. Some growth companies are indebted, some aren’t. Some have entrenched competitive advantages and therefore pricing power, some don’t. Some are creating whole new business models and products, others are locked in a fierce battle to undercut their competitors in the face of rising costs. Some earlier stage companies are well-funded and have a path to profitability, some have flaky business models and in a different funding environment would never have gotten off the ground. Some are cashflow positive, some continue to be reliant on now harder-to-secure external funding.
On the value side, some companies are cheap because investors have become hugely myopic and risk averse. Quite a few growth stocks have become value stocks in the past 18 months, without any real change in their operational prospects. Some other ‘value’ companies are cheap because they are in irreversible decline as their business models or products are replaced by newer, better ones.
Thinking about growth and value as opposing forces isn’t helpful. Really what we are talking about is differing investment horizons and approaches to investing. Simplistically, value is about buying companies that are currently under-appreciated by the market relative to their tangible value or earnings. Growth (at least to us) is about buying companies that are secularly under-appreciated by the market relative to their future earnings. No one’s actually trying to invest in the opposite of a value stock are they?
To invest in growth successfully requires both a very long investment horizon and the stoicism to stick with it, especially when horizons shorten. There is plenty of evidence that style and returns chasing by investors is far more damaging to individuals’ returns than the rotation of growth versus value or other style categorizations.
One of the most under-appreciated characteristics of stock markets is that, in the long term, market-wide returns are driven by an incredibly narrow range of companies. Research shows that most stocks—whether value or growth at any time—simply do not contribute much in terms of lifetime returns. From 1990 to 2018, if you had bought and held every available stock in global stock markets, 61% of them would have returned less than a US Treasury-bill. Only 38% did better, offsetting the losses of the first 61%. But the truly astonishing statistic is that the top 1.2% of companies increased in value by an amount equivalent to the entire rise in global stock markets over that time.
For long-term buy-and-hold investors with no skill in market timing—few companies are really all that interesting. It’s not about growth or value, it’s about trying to identify the small number of companies that have the potential to be truly world-beating. Is that even possible? Of course, it’s not easy and those who try to do it will be wrong a lot because we are trying to see 5–10 years into the future and beyond. But such companies do have common characteristics—quality, resilient management with very long horizons (often still founder-controlled), cultural strength, large and flexible application of their technologies and business models, and much higher than average research and development spend. Some of those companies will multiply their earnings many, many times and in the long run it is this which drives portfolio returns—not style, not macroeconomics, not interest rates and not inflation.
To return to our senior analyst: on the face of it, the analyst was wrong. But if they had instead simply written “the opportunity for great growth businesses in the next 10 years is as strong as ever,” then that’s something we would strongly stand by. Our world is still in the foothills of applying synthetic biology, artificial intelligence and personalized medicine to real-world problems, and the energy and e-commerce revolutions have far to go. Valuations of companies in those areas will fluctuate, but those that execute well and achieve worthwhile margins will drive stock market returns. As they always have done.
Stuart Dunbar is a Partner at Baillie Gifford