One of the current raging debates in the market is whether one should invest in Growth or Value. There is no fixed delineation of Growth or Value, but the generally accepted definitions are that Growth consists of fast growing and highly multiple (or no multiple) companies, while Value is defined as the slower growth of companies trading in low valuation multiples.
Material growth has surpassed Value over the past seven years but since the beginning of 2022 there has been a change in that trend. Many question whether this reversal from Growth to Value will be extended based on the return to the mean, higher interest rates, and Value is too cheap to ignore. On the other side of the debate is the inflationary environment, which requires investment in growing companies. This blog assumes that investors should avoid over -growth stocks and values without growth stocks, and instead look for growing companies that trade at reasonable values.
Growth has significantly exceeded value over the past seven years
Figure 1 illustrates that since the beginning of 2015 the MSCI ACWI Growth Price index has delivered 94% while the MSCI ACWI Value Price index has delivered 36%. This difference in performance is fully explained by multiple expansions because, in a few steps, the forward PE premium of Growth in Value widened from 40% at the beginning of 2015 to 100% today (Figure 2). Growth’s level of outperformance and its forward PE premium to Value is at a historical high that drives many to question if the rubber band has pulled too far and now it’s time to rotate Growth and towards Value.
Figure 1 – MSCI ACWI Growth index Vs MSCI ACWI Value index
Figure 2 – Forward PE multiples: Vanguard Growth and Vanguard Value ETF
Returning to the mean
The first reason to consider the Value rotation is the mean return. It can be delivered by a Growth PE premium that returns to its previous average of 40%. To deliver this result, the Growth PE multiple needs to contract 30%, while the Value remains stable.
A 30% contraction in the Growth PE multiple does not require all Growth stocks to drop by 30%. Figure 3 is a frequency histogram of the PE distribution of the Growth index. This illustrates that there is a long tail of companies in high PE multiples. Many of the companies trading in higher PE multiples are also large parts of the index, such as Amazon (PE = 141x), Tesla (59x), Nvidia (31x), Mastercard (32x), Salesforce.com (38x), Costco (36x), Nike (31x), and ServiceNow (65x).
The multiple Growth index premium may return to the historical average with normalization in the tail, which includes PEs of some larger stocks dropping more than 30%, and others dropping less than 10%. This means, a return to the mean can occur in material multiple contractions for firms in extreme multiples, specifically large firms in this multiple, and minor multiple contractions for most Growth stocks.
Higher interest rates are worse for Growth stocks
Rising interest rates should cause a lot of recession. The theory tells us that the value of an asset is the present value of all future cash flows. For a particular range of FCF/earnings, as interest rates increase the value of the asset decreases, which is another way of saying that increasing interest rates reduces valuation multiples.
The theory is demonstrated in practice. Figure 4 illustrates the broad inverse correlation between the PE multiple of the S&P 500 and the 10 -year treasury yield of the U.S. government, which we calculate has a correlation of -0.45.
Figure 4-S&P 500 PE at US government 10-year treasury yield *
The impact of changes in interest rates on asset assessments varies according to the prevailing interest rate environment. The lower the prevailing interest rate environment and the more intense the growth, the more noticeable the effect of changes in interest rates on valuation multiples.
Figure 5 illustrates theoretically correct PE multiples at different interest rates and growth rates and assumes a 5% equity risk premium. The chart shows that the PE multiple rises sharply with lower interest rates and higher growth rates. For example, in a 2% interest rate environment, an asset without any growth should be traded at a 14x PE, an asset with a 1% growth rate should be traded at a 17x PE, and an asset with a 3% growth rate should be traded at a 25x PE.
In an environment with the lowest interest rates in three generations, it is understandable why valuation multiples are now at extreme levels and Growth stocks are trading at higher experience -related premiums.
Figure 5 – Theoretical PE multiples at different interest rates and growth rates *
Rising interest rates today are reversing the above trends and having a devastating effect on high multiple stocks providing another argument for the transition from Growth to Value. Pella believes this is a very simple argument. First, it is primarily relevant to companies whose growth is fully embedded in the analysis and that rising interest rates will have a lower impact on stocks that are cheap compared to their growth outlook. Another way of communicating this argument is that formerly growth was the only thing that mattered but now appreciation is also important. The importance of appreciation (low PE -related growth) is different from contention value (low absolute PE).
The second problem with the argument of shifting from Growth to Value due to rising interest rates is that it assumes that interest rates will continue to rise for the entire investment holding period (e.g. three to five years) . As explained in our previous blog, ‘Why won’t tight monetary policy continue ‘ (10 Mar-22), Pella believes there are material barriers to continued tight monetary policy and the Fed will likely be forced to stop the tightening cycle sooner than many currently expect.
The cost is too cheap to ignore
Given Value has material poor performance Growth Is it possible that Value is so unloved and cheap that it will certainly outperform performance as the importance of appreciation increases? According to our calculations that is not the case and the Value is valued fairly.
We applied the Vanguard Value ETF as a benchmark for the Value market because that ETF has a long historical trading history and reliable PE numbers. Figure 6 illustrates the difference between the earnings of that ETF (as opposed to PE) and the 10-year treasury yield of the U.S. government. Anything in the top half of the chart (above the ocher line) represents instances where Value is cheap in relation to history and in the bottom half is where Value is expensive in relation to history. This shows that right now, Value is relatively valued in relation to history, and not so cheap that it cannot be ignored.
Figure 6-Vanguard ETF earnings value yields less 10-year treasury yield
Growth is important when there is sluggish real growth or high inflation
Now is the time to make the case for the importance of Growth in the current environment. Inflation is at multi-generational highs and as we stated on our blog ‘Why will high inflation continue ‘ (23 Feb-22), it is unlikely to drop to low levels in the near term. In this environment, growth is critical and not investing in growing companies is ironically equivalent to a bet on multiple expansion.
Inflation eats up real profits and any company whose profits don’t grow, at least at the inflation rate, is destroying value. Just because of the economic basis, growth becomes increasingly important as the inflation rate rises.
There is also the consideration of the effect of inflation on a company’s earnings. Companies that do not grow their profits before their cost base will have declining margins, which is an antidote to revenue growth. In fact, in many situations the margin headwind can result in lower revenues, which is a relentless catastrophe during the inflationary period.
The above means that the only way to make money from stocks that do not generate real growth is through multiple expansions. This is a frightening prospect in a rising interest rate environment, which (as discussed above) is a headwind in valuation multiples. The alternative is to invest in companies that grow above the inflation rate. In other words, Growth is critical during the inflationary environment.
Conclusion
In the above discussion, we argued that a return to the historical Growth PE premium to Value PE does not require all Growth stocks to decline and can occur with a substantial decrease in outliers. This is likely to happen as interest rates rise due to such low interest rates, a small increase in interest rates will have a huge impact on companies with massive appreciation. As a result, appreciation is needed, but that’s different from just investing in ‘Value’ because that segment doesn’t look too cheap by historical standards. Furthermore, it is critical to invest in growing stocks during the inflationary period.
The conclusion of the above is to stay away from extreme Growth stocks and stocks that are not consistently growing and seek refuge in growing stocks trading at reasonable valuations. Pella seeks to do this using our valuation-growth curves associated with theoretically correct valuation for each growth level to help guide our investment decisions. Some ideas that fall into this review include Dollar General (growing 8% more and at a 19x PE), Deutsche Boerse (growing at HSD and at a 17x PE), Cigna (5% growth and 12x PE) and JD Sports Fashion (high single digit growth and 10x PE).
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