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The Growth – Value Pendulum

Any sensible investor will tell you that the choice between growth and value styles is not binary. There’s ample room for both in a diversified equities portfolio. Nevertheless, it’s wise to revisit the debate and understand it in the context of various economic backdrops. Although completely abandoning one style for another seems foolish, tilting a portfolio at different points in the cycle is worth considering.

Before reaching any actionable conclusions, consider why investors buy equities in the first place? Generally speaking, stocks are representative of economic activity in a country or region—or since the market is a discounting mechanism, the anticipated economic activity of said region. Investors buy stocks to capture growth, which should be roughly equivalent to GDP, plus some potential dividend or inflation component. A company may also be leveraged to some degree, providing another possible tailwind for earnings growth.

When companies are positioned to grow faster than the economy of a specific region, they typically command a premium price. And, of course, the reverse is true as slower growers trade at a discount.

In a slow-growth economic environment, investors often aggressively seek out companies poised to surpass the rate of economic growth. This has been our reality for over a decade, and not surprisingly growth strategies have excelled during this period versus their value-oriented counterparts. Of course there are countless reasons for why individual companies may be growing quickly, including technological innovation, scientific discovery, or even a disruptive (more efficient) business model.

On the flip side, value stocks tend to outperform when one of two things happens. If high-growth (and high-multiple) companies stumble and expectations are lowered, that often sends investors headed to more attractive valuations. Fast growers can be penalized for poor execution, new competition, or even their natural maturation and the law of large numbers.

Another reason that value stocks gain traction is when we begin to see regional or country GDP accelerate from very low levels. This can be the result of either exogenous stimulus or heightened demand and the rebuilding of inventories. Another tailwind for value strategies may come from companies that have cyclical exposure, which in combination with low valuations, provides a potential long runway for earnings growth. This was the scenario from 2003 to 2007 when value strategies outperformed. Are we on the verge of a repeat?

Of course, recency bias is real, and it’s difficult to remember back to when high-growth, high-multiple companies were laggards. It may not be coincidence that monetary policy of recent years has also tilted the playing field. A Federal Funds interest rate hovering near zero drives sentiment, and an argument can be made that the era of cheap money has also caused some reckless behavior. Borrowing and risk-taking are rewarded, perhaps too much. This era of quantitative easing may have been instrumental in resuscitating markets earlier this year, but can it continue forever?

At some point—perhaps soon—the pendulum may swing back to favor value strategies. It could come as high growth companies begin to slow their roll. It could come as GDP begins to rebound in a post-pandemic environment. And it could come if and when the Federal Reserve begins to normalize policy. Thus, investors should ask themselves: Will growth investing dominance go on forever?

©2020 Victory Capital Management Inc.


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