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Insights

Growth and Value investing not always at loggerheads

June 2021

By Simon Elimelakh, Head of Investment Portfolio Analytics

A lot has been written on the size and speed of the March 2020 ‘COVID crash,’ and stunning recovery in record time, so I’ll do my best to avoid going over well-worn ground in this discussion of share markets.

What might be less well-known are nuances like the fact that major share markets, such as the US S&P 500 index, delivered positive returns over calendar 2020 despite volatility averaging about 34.5%.1 This made it the second most volatile year since the early 1930s. The S&P 500 returned about 16.3% on a price basis, after falling 33.9% over 19 February – 23 March last year.2

High volatility is usually not friendly to share markets, but last year was an exception.

Between 1928 and 2020, when volatility was higher than 20%, S&P 500 returns were negative around 71% of the time.3 By contrast, when volatility was lower than 20%, returns were positive about 78% of the time.4

The remarkable revival was due to the gods of massive central bank and government intervention. The size of central bank and government financial support, rushed out over just a few weeks, was so large that it surpassed the level delivered over the entire 2008/2009 Global Financial Crisis period!


Markets driven by P/E expansion


Another feature of the past year is that equity markets ran well ahead of real economic improvement with share prices going up much more than underlying company earnings. In other words, price to earnings ratio (P/E ratio)6 expansion has driven share markets forward, rather than rapidly rising profits. This shouldn’t be a surprise given all that’s transpired.

For many companies, business activity was effectively shut down for a large part of 2020 and tentative steps towards normalcy only began late in the year. Consequently, reported corporate earnings growth for many companies was lacklustre for much of the past 12 months, and only started to revive recently.

We estimate that the S&P 500 Index’s P/E ratio went up about 38% over the 12 months to the end of May 2021, significantly outpacing the reported 10% earnings growth over the period.7

The 10% figure needs some perspective. For the 12 months to the end of April, S&P 500 companies reported earnings growth of just 1%, but a month later, by the end of May, they reported 10% earnings gains for 12 months.8

Two further points need to be made about the 10% figure. Firstly, a lot happened in a month on the earnings front between April and May this year. Secondly, earnings were down significantly in April/May 2020 and this set a lower base for future earnings growth. In other words, the 10% growth in reported earnings to May 2021 looks better than it was because earnings were moving down a year ago.

Yet, none of this was a handbrake on markets as interest rates have fallen to more than compensate for earnings growth that only started to improve lately off a lower base. In a world of negative real interest rates, the future value of companies’ cash flows, measured in current terms, have become more valuable, which has caused valuations to swell.

Absent further falls in interest rates — a tall order as the global economic pulse quickens and inflationary pressures emerge — impressive earnings growth will be needed to push share markets forward.


“The S&P 500 Index’s P/E ratio went up about 38% over the 12 months to the end of May 2021.”


Positive earnings expectations


The good news for investors is that the earnings picture for many companies is now looking promising. In addition to the recent pick-up in reported earnings, there are positive earnings expectations for both the S&P 500, and the Australian market, measured by the MSCI Australia Index.

The 12 months forward consensus expectations for the S&P 500 Index is for more than 20% earnings growth (Chart 1).

Chart 1: US company earnings expectations are positive…
US earnings growth (year-on-year) for S&P 500 Index

As of 31 May 2021
Source: Datastream, FactSet, MLC Investments Limited
Past performance is not a reliable indicator of future performance.


The Australian picture is broadly similar, albeit not quite as upbeat. Like the US, trailing/reported earnings have improved about 10% since May 2020, and 12 months forward consensus expectations are for 15% earnings growth (Chart 2).

Chart 2: …as are earnings expectations for Australian companies
Australian earnings growth (year-on-year) for MSCI Australia Index

As of 31 May 2021
Source: Datastream, FactSet, MLC Investments Limited
Past performance is not a reliable indicator of future performance.


To be clear, earnings expectations are not predictive of market performance. After all, the earnings outlook was positive coming into the March quarter 2020, and we know what happened.

That said, earnings expectations are indicators of the business and economic outlook based on current information, and for now, at least, the information appears encouraging.  

However, as has been the case over most of the past year, progress against COVID-19 will be key.

Vaccine rollouts are taking place across major economies, but threats of new outbreaks and new COVID strains, with their capacity for disruption, cannot be discounted. Medical professionals have been warning that we are going to have to learn to live with COVID-19, in some form.

There is ever-improving scientific understanding of the virus and pandemic-management, but the sobering reality is that medicine has only ever eliminated one disease, smallpox.
 

“Earnings expectations are not predictive of market performance. That said, today’s positive earnings expectations are indicators of the business and economic outlook based on current information, and for now, at least, the information appears encouraging.“

 

Growth and Value styles can do well simultaneously


Finally, I want to address the issue of investment style performance. The conventional wisdom is that the post GFC decade, as well as 2020, was good for Growth equity investing, but bad for Value investing.

This assumes that investing is a zero-sum game where what’s good for Growth must automatically be bad for Value and vice versa. This proposition would only be true if you divide a market into two components — say ‘naïve Growth’ and ‘naïve Value,’ as is the case for the widely used MSCI Value and MSCI Growth indices. In this case, one would simply be the exact opposite of the other and when one is positive, the other must necessarily be negative.

The reality is more nuanced than naïve portrayals of Growth and Value investing. The truth is that periods of simultaneously positive performance for Growth and Value stocks are not that rare, it’s just that they’ve been rare since 2017 (Chart 3).

Chart 3: Periods of simultaneously positive returns for Growth and Value stocks are not that rare
Global Value and Growth stocks: 12-month rolling returns

References to Value and Growth in this chart are taken from MSCI FaCSTM, which is a classification standard and framework for evaluating, implementing and reporting style factors in equity portfolios. Data for this chart  is from the MSCI Barra Global Equity Factor Model (GEMLT), and represents a pure, neutralised representation of investment style returns.
As of 31 May 2021
Source: MSCI BARRA, MLC Investments Limited
Past performance is not a reliable indicator of future performance.


Moreover, our analysis reveals a 65% correlation between our Global Equity multi-manager sector portfolio’s 12 months alpha and the average of 12-months Value and Growth returns (Chart 4).

Said differently, periods when both Value and Growth are doing well are supportive for multi-managers like us. From our perspective, this emphasises that Growth and Value investing are not permanently at loggerheads, rather they are on a continuum. Furthermore, the data demonstrates the effectiveness of multi-style, multi-manager, complementary portfolios, over the long term.

Chart 4: Value and Growth style returns reveals a 65% correlation
MLC global shares strategy (MLC) outperformance vs average of Value and Growth

As of 31 May 2021
Source: Source: MSCI BARRA, MLC Investments Limited
Past performance is not a reliable indicator of future performance.


“Periods of simultaneously positive performance for Growth and Value stocks are not that rare, it’s just that they’ve been rare since 2017. Our analysis reveals a high correlation between our Global Equity multi-manager sector portfolio’s 12-months alpha and the average of 12-months Value and Growth returns.
 

Our experience is that style-driven, flexible managers leaning on strong stock-picking skills can perform relatively well even in seemingly style-hostile environments.”

 

Many Growth managers are sensitive to valuation considerations when selecting stocks and don’t simply buy growth at any price. By the same token, many Value managers look for stocks exhibiting some growth/quality characteristics such as good return-on-equity, and balance sheet strength.

Our experience is that style-driven, flexible managers leaning on strong stock-picking skills can perform relatively well even in seemingly style-hostile environments.


Benefits of style diversification


Adopting style diversification, in this instance, investing in both Growth and Value managers, and adjusting their weights based on a balance of changing risk and return potential has been a hallmark of our four-decades investment approach.

Undoubtedly, it does run the risk of giving up some return potential, when one style outperforms strongly, but it also dampens overall risk by not wildly preferencing one style of investing.  Style diversification helps to cushion our equity portfolios against sharp drawdowns9 associated with single-style investing.

Investing in shares is often a long-term commitment for many people and thus we believe that investing with multi-managers, like us, is a good way of achieving superior long-term risk-adjusted returns, particularly for risk-conscious investors.

1 Volatility measured as realised volatility on the basis of daily price movements.
2  Source: FactSet.
3 MLC Investments Limited analysis of FactSet data.
4 Ibid.
5 Timeline: Fed's response - pandemic downturn vs financial crisis, by Ann Saphir, Lindsay Dunsmuir, 10 April 2020, https://www.reuters.com/article/uk-health-coronavirus-fed-timeline/timeline-feds-response-pandemic-downturn-vs-financial-crisis-idUSKCN21R2FD?edition-redirect=in, accessed 2 June 2021.
6 The price-earnings ratio, also known as P/E ratio, P/E, or PER, is the ratio of a company's share price to the company's earnings per share. The ratio is used for valuing companies.
7 MLC Investments Limited analysis of Datastream and FactSet data for the 12 months to 31 May 2021.
8 MLC Investments Limited analysis of Datastream and FactSet data for the 12 months to 30 April 2021, and 12 months to 31 May 2021.
9 A drawdown measures the lowest point of an investment after its most recent high-water mark.

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