Blog: Value investing: is the tide turning?
Growth or value? That has been the question on many investors’ minds as markets took a turbulent turn through the autumn months. They represent the two main schools of thought when it comes to investing and investors often try to lump stocks into one or other of the two categories. Of course, it’s not so clearcut as Box A for fast-growing glamour stocks and Box B for dowdy, old cheap shares – the lines are often blurred. Both have their draws, writes Alasdair McKinnon, manager at The Scottish Investment Trust.
Growth stocks inspire hopes and dreams, and investors strap themselves into the love train, usually paying up for the thrill. Value stocks, on the other hand, are the lonely singletons of the stockmarket world – they are priced for their less obvious charms and astute investors can pick up a hidden gem without betting the farm. Of course, investing is full of ups and downs and no style is ‘right’ or ‘wrong’ all of the time – they go in and out of fashion. This raises an interesting question – as the rally in growth stocks gets long in the tooth, are the value stocks that have been long overlooked a budding contrarian opportunity?
For over a decade, growth stocks have been cresting the wave of loose monetary policy leaving value stocks languishing in the doldrums. The tide may be turning and, as contrarians, we’ve been keeping a watchful eye on these contrasting fortunes.
Firstly, let’s consider why growth stocks have fared so well. It’s not by chance that the strong performance over the last 10 years coincides with the decade following the global financial crash. The conditions that ensued have been unusually flattering for growth investments.
Stunned by the severity of the crisis, central bankers took the unprecedented action of cutting interest rates to near zero and launching quantitative easing (QE) – a scheme that injected cash into the financial system via the central bank purchase of, mostly, government bonds. As growth stocks are often valued by discounting their future cash flows into a ‘present value’ and, given that most of their profits will be earned in the future, lower interest rates made these stocks look far more appealing to investors using this measure.
Turning off the tap
But 10 years on, the fuel for this cheap money appears to be running out. The US has begun withdrawing QE, while the European Central Bank plans to make no more purchases beyond December. Central banks’ withdrawal of accommodative policies, alongside rising yields, creates an environment less supportive for growth stocks, effectively reversing the valuation argument described above.
The trend of increasing interest rates is exacerbated by the rise of populist politicians to power, who are throwing budgetary caution to the wind to satisfy their voter bases. We have seen this lately in Italy, where the country’s anti-establishment government announced a budget that will conflict with the EU’s rules.
There’s also the question of market cycles. The post financial crisis conditions we discussed earlier have prolonged the bull market for growth stocks – we believe that a number of growth companies are in bubble territory. They’re ‘priced for perfection’ and even the smallest disappointment could lead to a share price correction. Some of the internet and technology stocks, characterised by the FANGs, fit this bill. If these companies do fall off their perch, value stocks may well benefit from a rotation of investment flows. Certainly, the balance between risk and reward of growth stocks is less favourable.
Looking at value through a contrarian lens
Contrarian investment is distinct from value investing, but the two styles do have some things in common at this point in time. Both aim to identify undervalued stocks that have the potential for an improvement in circumstances. However, as contrarians, we also specifically seek out unfashionable and unloved stocks where we believe sentiment is overly pessimistic. As we know, market sentiment towards a company can quickly change and that the sentiment cycle tends to swing too far, thereby creating investment opportunities. Part of our job is to identify and investigate these opportunities, looking for tangible signs of positive change. For example, these could include new management, a turn in the industry cycle or other factors that the broader market has overlooked and underestimated.
Our ‘belt and braces’ approach means that, as well as being unloved, we like companies to have strong balance sheets that facilitate planned change and support dividends to provide us with income while we wait for the tide to turn. In the current climate, there are many interesting opportunities for contrarian investors. Areas such as Brexit blighted Britain, Europe and recently battered emerging markets may all prove fruitful hunting grounds.
Taking a contrarian position can be uncomfortable – it often takes time for change to be recognised, meaning that patience is a necessity. Because ours is an independent, closed-ended fund, we have the freedom to commit to this long-term approach for our investors. We’re in pursuit of the most compelling contrarian investments and those are not found in asset bubbles or ‘hot trades’. Value stocks might appear out of favour now, but when the sea change comes, these could become fashionable again.