Why Growth Stocks Have Outperformed Value in an Unstable Market
Growth stocks have outperformed in the aggressive market sell-off despite lots of factors that would indicate an inclination for value. Kevin Preloger, Perkins Portfolio Manager, explains the reason and discusses how the recent instability could affect value versus growth leadership going forward.
It is a bit contradictory, growth stocks have outperformed during the latest market sell-off in spite conditions that appear to favor value: stretched valuations for growth stocks, slowing earnings growth, the historical tendency for value to outdo growth in the late stages of the economic cycle and, finally, an anticipated return to the mean where value leads following an extended period of growth performance.
Still a year to date, and more recently since markets peaked in February, value indices are slowing their growth counterparts across all market capitalizations.
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The Reason Why Growth Has Outperformed
So, what is the reason why has growth outperformed? Other investors said many times that the overall market’s valuation was stretched.
Growth stocks still show expensive, but some value stocks with a preference to defensive characteristics trade at a small discount to the market, offering a margin of safety.
Investors, maybe have choice toward the long-running outperformance of growth stocks in the bull market, they seem to stick with what has been working and ignoring the risk of extended price-to-earnings (P/E) multiples.
Health care is an excellent example of a sector where valuations remain elevated, specifically for medical-device and smaller-cap biotechnology stocks.
Even though many healthcare-related areas are recession-resistant, the P/E multiples are still relatively abundant, leading to unsightly reward-to-risk ratios.
Large-cap pharmaceuticals, where valuations are more attractive, are an exception, but investors believe political policy risk remains.
Taking into the account the negative effect of the COVID-19 pandemic, it now shows that the S&P 500 Index earnings could be flat, at best, in 2020, which could result in the second consecutive year of zero growth.
Earnings estimate cuts made in these early stages of the virus pandemic, so it would seem acceptable that more could follow given the effects spreading to more nations and supply chains.
Lots of the return in stocks for 2019 and earlier this year were due to multiple expansion, thereby stock prices climbed faster than earnings, leading to higher P/Es.
As earnings pressure becomes more evident through this year, multiples could compress and lead to more pain, especially from high-multiple growth stocks, specifically in the information technology sector.
Going Against Historical Trends
Typically, we would expect the value to outperform in the late-cycle circumstances where we see a slowing of growth.
On the other hand, the aggressive nature and speed of the latest sell-off together with new headwinds for conventional value sectors like financials, energy, and other cyclical seemingly changed the historical pattern.
Cyclical areas, like the banks, industrials and materials, which tend to be overly indexed to value benchmarks, are punished materially year to date as investors calculate the consequences of a slowing economy due to the coronavirus.
Moreover, two new variables – significantly lower oil prices and interest rates – are likely to have a material opposing effect on the earnings of banks and energy companies soon.
The good news, for the banks at least, is that we believe the impact of the COVID-19 on the global economy could be temporary, resulting in the potential for significant bargains in the beaten-down sector.
The sector of energy is more challenging because there are issues in the supply and demand side.
On the supply side, prices have collapsed as opponent OPEC (Organization of the Petroleum Exporting Countries) member countries saturate the market with crude, resulting in an indefensible situation for many exploration and production companies.
On the demand side, broad swaths of the world are under temporary quarantine or travel restrictions, effecting in less demand for refined products.
While the energy sector is now out of favor, the balance sheets of lots of these energy companies depict a “no-go” zone for defensive value investors.
On the positive note, buyers should see much lower prices at the pump, and significant industrial users should benefit from an essential reduction in input costs.
Stocks that are beneficiaries of lower energy prices may be more attractive for investors.
The limited leadership of favored growth stocks recommends that in this market environment, investors have stuck with what has been working.
Instead of reverting to the mean, the growth bias has continued. Nevertheless, given growth’s extended period of outperformance, we still anticipate a leadership change from growth to value.
We believe investors will eventually look to cheaper offerings that are marked notably lower, making value stocks much more appealing.
The aggressive nature of this sell-off is immensely different than other market drops we have gone, whether it was the 2000 dot-com bubble, post-9/11, the Global Financial Crisis or other instability-producing events.
In this situation, we have confidence in a long-term perspective, and a focus on high-quality stocks with defensive characteristics is wise, given the potential for downside protection.
This market drop may show the opportunity to reevaluate reward-to-risk ratios and discover high-quality companies on sale.
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