Value vs Growth

[윤영준]

The last three years are characterized by an unprecedented fast-moving economic cycle. The pandemic-induced lockdowns brought some parts of production to a standstill. A deep but brief recession was followed by a frantic recovery supported by gigantic fiscal and monetary policies. Then came inflation. Over this chaotic period, business environment has also changed profoundly. As a result, market leadership in terms of stock market performance has flipped dramatically. The best performing industries over the past three-year period are energy and IT: respectively the archetypes of the value style investment and its anti-thesis, growth style, although their performance went through a huge switch-over.

After a prolonged period of underperformance, value stocks have outperformed growth counterparts globally by a big margin in 2022. To be more precise, value stocks delivered a less negative return compared to -25% return from growth stocks. Value’s strong performance seems to be primarily about avoidance of dramatic falls of over-rated technology stocks. There are several factors for this performance difference. One of them is that as interest rates rise, growth stocks fare worse than value stocks because the present value of a growth stock is supported by cash flows far in the future: higher interest rates mean those far-out cash flows are discounted at a higher rate. This includes a lot of technology stocks which were in a bubble under near-zero interest rates and they simply popped. In addition, the performance of value stocks got a big impulse from energy stocks this year as energy prices soared since the Russian invasion of Ukraine.

In fact, equity markets globally suffered heavy losses in 2022 as the Fed and other central banks have been hiking interest rates to curb inflation, sharply driving up the cost of capital for companies. This has translated into a drop in valuation, especially in growth stocks whose earnings are expected to materialize further in the future. However, our calculation shows that the total increase of the cost of capital is rather modest because the rise of long-term bond yields has been partly offset by the decline in equity risk premium. With the heightened uncertainty regarding future inflation and monetary policy, risk of government bonds has risen significantly, which is reflected in an elevated MOVE index. As a result, the relative risk of equity, aka equity risk premium, has been compressed.

More critically, tightening financial conditions dampen the economic activities and the prospects for growth stocks have changed. The revenue from growth stocks has grown much faster than the overall index for the last decade, in particular, during the outbreak of Covid-19. But that extra revenue growth has shrunk, and earnings of growth stocks have fallen behind analysts’ expectation. Large-cap technology companies known as FAANG+, which led the outperformance of growth stocks in 2020 and 2021, become laggards in 2022. However, their performance diverges from each other to a great extent (Chart below). Hence, the underperformance of growth stocks cannot be attributed solely to higher interest rates. As shown in the Chart below, the main driver behind the performance difference is their future earnings. Apple has managed to retain its post-Covid gains because it is supposed to deliver its earnings in 2023 as expected. On the other hand, Amazon and Netflix have seen their stock prices back to the level at the beginning of 2020 whereas Facebook (Meta) is well below its starting price. This can be explained by a substantial downgrade of their future earnings. In effect, actual damage is inflicted on the numerator rather than on the denominator of valuation. We observe a similar trend in the index level; the earnings outlook of growth stocks in general has been more substantially downgraded.

Can we expect for value stocks to continue outperforming growth stocks in 2023? From the relative valuation perspective, value stocks are still trading at a much wider than normal discount to growth stocks: the gap between the valuation of cheap and expensive stocks remains very wide albeit some catch-up in 2022. Given a great deal of uncertainty over what the world is going to look like over the next three to five years from now, investors may be less interested in paying a big premium for companies based on what those companies are promising to deliver in three to five years. In uncertain times, certainty of cash flows is preferred to the promise of future growth. And we think that inflation is still a crucial source of uncertainty. Under a high inflation environment, the increased cost of funding will give a lift to established companies across the economy as they are able to generate positive cash flows from legacy investments. The high-growth technology companies, for example, give ground to old-economy bricks-and-mortars as long as inflation remains elevated and funding cost stays high.

Many anticipate a recession in developed economies including the US as central banks continue to hike interest rates in 2023. Even if it may be a mild recession, corporate earnings will be dragged down with the slowing economy. With reliable near-term cash flows, there is a further room for value stocks to close the valuation gap. Under such a circumstance, value stocks appear to be a safer bet than growth stocks until the recession is over and interest rates start to come down.

[솔재지킴이]

윤박사님, 계속 좋은 글 올려주셔서 고맙습니다.

[좋은세상]

다녀갑니다.