MARK SEYMOUR: Equity market valuations matter in rising inflation environment
Investors are nervous as corporate earnings are likely to weaken as central banks raise rates
The relative performance comparison between value stocks and growth stocks swings wildly from one period to the next. For example, the MSCI value index underperformed the MSCI growth index by 28% between the start of the Asian crisis and the height of the dot-com bubble (October 1997 to February 2000).
Value stocks rebounded, outperforming growth stocks by 92% over the following seven years from the top of the dot-com bubble to a year before the global financial crisis (2000 to 2007).
Value stocks then reversed their fortunes, woefully underperforming growth stocks over the subsequent 13 years (2007 to 2020), relinquishing all of their realised gains between the dot-com bubble and the global financial crisis. More recently, value stocks have re-established their dominance with a 30% relative outperformance since the post-Covid market recovery (August 2020 to present).
Despite the wild swings in relative returns over the past 34 years the performance of value and growth stocks have been identical, suggesting that there is no significant superiority between the two strategies or styles of investing over the long term.
To understand the drivers of returns for the two styles, it is worth noting the characteristics that decide whether a stock fits into the growth or value index. Value investors look for securities whose prices appear low compared to their intrinsic value, while growth investors focus on identifying securities whose prices they believe will be driven by outsize sales and earnings growth.
More formally, the variables used to specify stocks for inclusion in the MSCI Global Value index are book value to price ratio; 12-month forward earnings to price ratio, and dividend yield.
The following measures are used to specify stocks for inclusion in the MSCI Global Growth index:
- Long-term forward earnings per share (EPS) growth rate,
- Short-term forward EPS growth rate,
- Current internal growth rate,
- Long-term historical EPS growth trend, and
- Long-term historical sales per share growth trend.
The critical distinction between growth and value stocks is that price is a determining factor for classifying value stocks, whereas price is not a consideration for categorising growth stocks.
Interestingly, there is a definitive relationship between market valuations and the relative performance between value and growth stocks. The value index outperforms the growth index when the overall market is expensive (low real earnings yield). The growth index outperforms the value index when the market is cheap (high real earnings yield). For example, at the height of the dot-com bubble the real yield on the S&P 500 reached a low of -0.5% (April 2000), and the value index began to outperform the growth index.
Conversely, when the S&P 500’s real yield reached a high of 4% (October 2006), the growth index began to outperform the value index. Over the following 13 years inflation moderated from 4.5% to 0% (at times), and corporate profits rallied. The combined effect of falling inflation and solid corporate profits resulted in sustained high real yields, even as markets ran.
It would seem that when the market is trading at attractive valuations and macroeconomic conditions are favourable, investors are more comfortable and willing to buy stocks with attractive growth metrics, regardless of price. Conversely, when investors are nervous about unfavourable market valuations and macroeconomic conditions, they migrate to relatively cheaper market segments, resulting in better relative performance from “value” stocks.
The problem facing investors now is rampant inflation. Abnormally high inflation has a three-fold negative affect on company valuations: higher discount rates applied to future cash flows, lower corporate earnings as inflation drives down margins, and lower top-line growth from weakening demand.
The commonly agreed causes of the recent inflation are the combined effect of the immense fiscal stimulus (a necessary response to the Covid crisis) coupled with supply chain dislocations resulting from lockdowns and severe war-related sanctions. This extraordinary mix of factors has translated into high inflation, a challenging problem for central banks to solve given that they only have the tools to influence and suppress demand.
As a result, investors are nervous about the future, real earnings yields have dropped to historic lows and corporate earnings are likely to weaken as central banks raise interest rates to tackle inflation.
Under these conditions it is understandable that equity investors are nervous and shifting their focus away from stocks with historically strong growth projections to “value” stocks on price multiples that are relatively more attractive. The question is, are valuations attractive enough to weather the potential hurricane, as JPMorgan Chase CEO and chair Jamie Dimon put it. In this case, more than ever, valuations do indeed matter.
• Seymour is director: fixed income at North Star, and co-portfolio manager of the Global Flexible Fund and SCI Income Fund.
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