Global value stocks still trade at a near-record discount to growth stocks, even after handily outperforming since November. That’s a huge turnaround after growth stocks had dominated for many years. So what was behind the prolonged winning streak for growth that created today’s extreme valuation gap?
To answer that question, let’s start by looking at returns from 2015 through 2020, when value’s underperformance was most pronounced. During that six-year period, global value stocks trailed global growth stocks by 9.5% per annum. That adds up to an astonishing cumulative gap of 92% in favor of growth stocks (Display). As a result, value stocks traded at a 53% price/earnings discount to growth stocks at the end of 2020; by the end of May value stocks were still 51% cheaper than growth peers.
Growth’s outperformance through 2020 was driven by some surprising trends. In the absence of multiple expansion, a stock’s return is determined by dividends paid plus earnings growth. Normally, we would expect the difference in earnings growth and dividends to explain most of the performance differential between value and growth stocks.
Not this time. Our research shows that only 10 percentage points of the return gap between value and growth stocks since 2015 were driven by the difference in earnings and dividends. Multiple expansion accounted for the remaining 82 percentage points of the performance differential.
Do Multiples Matter?
Many investors don’t seem to care about multiples. After all, does it really matter where returns come from if you can enjoy a profitable bonanza by investing in growth stocks? We think it does. In our view, understanding the sources of historical returns is crucial for evaluating the outlook—because in some conditions, multiple changes can quickly reverse.
The relatively small return gap owing to dividends and earnings growth tells an important story. Many investors believe that growth’s dominance has been propelled by dramatic changes in business trends that have favored growth-oriented companies in recent years. Yet the 10% difference in earnings and dividend performance—about 1.5% per year—suggests that these seemingly seismic business shifts haven’t made a huge difference to profits and cash flows, which ultimately determine a stock’s value.
Instead, investors have simply chosen to reprice the growth cohort. Even before the pandemic, investors pushed up share prices of growth stocks, while pushing down value stocks disproportionately to the actual disparity in profitability.
Why Have Value Earnings Lagged?
To be sure, value companies’ earnings have lagged those of their growth peers. That’s largely because value companies are generally more sensitive to changes in the macroeconomic cycle than are growth companies. And global GDP growth has been rather tepid in recent years, even before COVID-19.
So in 2020, when the pandemic triggered economic shutdowns and GDP crashed, earnings of value companies took a bigger hit than that of growth companies (Display). In a socially distanced, work-from-home world, some growth companies—particularly those offering digital services in the technology and consumer sectors—benefited from an acceleration of shifts in demand that were already under way.
Widespread disruption across industries, which had begun before the pandemic, also helps explain the divergence of value and growth earnings. Disruption has often been the result of powerful network effects—business models and platforms that generate outsize demand in the internet economy, from social media companies such as Facebook to consumer giants such as Amazon. As a result, platform companies that benefit from network effects have posted much faster sales growth than have the broad global market and US growth stocks. These companies have created a moat around their businesses with revenues and profits that are less vulnerable to competition.
This trend helps explain why the revenue growth of growth companies has outpaced that of value peers. In several industries, technological disruptors are shaking up traditional business models and grabbing a larger share of business. Companies such as Amazon, in retail, and Salesforce.com, in software, are making life much more difficult for rivals such as Target and Oracle. In many cases, we believe share prices have been rewarded for outstanding revenue growth, even if it hasn’t always translated into superior fundamental performance for profits or margins.
Then perhaps the fundamentals of value companies have deteriorated dramatically? In fact, by the end of March, the forecast profitability of value companies, as compared to growth companies, was well above average given expectations for a strong cyclical recovery. And value balance sheets (net debt to equity) were also stronger than usual, relative to growth companies, based on data from 1997 (Display). So the huge value discount clearly doesn’t stem from any major degradation in fundamentals overall, in our view.
So, why did the value discount widen to historic proportions? We see three primary reasons: (1) the fall in interest rates, (2) an increase in the premium paid for revenue growth and (3) a divergence in risk premiums amid weak economic growth, the pandemic-induced recession and a more uncertain future. In our next blog, we will take a closer look at these three forces, as their unwinding could propel a sustainable recovery of value stocks through the global economic recovery from the pandemic.
- Avi Lavi
- Chief Investment Officer—Global and International Value Equities; Portfolio Manager—Global Research Insights
This blog is the second excerpt in a series based on our recent white paper Value’s New Hope: Will the Pandemic Exit Be the Catalyst?, published in March 2021.