The relative performance of growth against value stocks in January as measured by MSCI has now been worse than any time since the 1970s, which suggests that the trade is now overplayed.
This is what Sharon Bentley-Hamlyn at Aubrey Capital Management believes. The investment manager argues that the prospect of interest rate rises continuing to ravage growth stock valuations seems to have done its worst.
“It is always as well to remember that the best growth companies are almost always backed by structural long-term trends, and value stocks are not. They are just being driven by short-term cyclical triggers, notably short-term interest rate speculation.
Short-term supply issues
Current inflation, which is behind the speculation about rising rates, is not due to overheating economies but rather the result of short-term supply side shortages, Bentley-Hamlyn argues.
“Higher interest rates will have no impact whatsoever on these shortages. They will just pressure economic growth. That is why we believe that four interest rate rises in the US are unlikely and market will be pleasantly surprised.”
She adds: “It is certainly true that the European index has been propelled by cheap banks, materials and energy.
Given what we see from consensus forecasts, the increase in profits amongst value stocks which was spectacular in 2021, largely because the base effect of a Covid-challenged 2020, will remain healthy this year before falling off a cliff in 2023.
“It is therefore reasonable to assume if these sectors take a breather, then the 25% increase that we saw in the index last year may not be repeated.”
Despite growth stocks having a tough time this year, Bentley-Hamlyn is confident that the average profit growth for the stocks in her portfolio will be significantly higher than the fund’s benchmarks the MSCI Europe Value EPS profit growth, the MSCI Europe Growth and the MSCI Europe this year.
Bentley-Hamlyn prefers not to get drawn into the old Value/Growth debate, she just reiterates the fact that she only invests in stocks that have growing profitability and are backed by structural long-term trends.
Richard Halle, fund manager at M&G investments, has his own take on things. He says the 13-year long trend against value as a style accelerated during the Covid-19 pandemic, albeit with a brief pause, and resulted in a situation where the valuation dispersion between the cheapest and the most expensive stocks in the market is now as extreme as at any time in history.
His assessment is that this market pricing has been driven primarily by behavioural factors, more than underlying company fundamentals: a self-reinforcing cycle of a long-run trend combined with an anchoring bias extrapolating these trends indefinitely, driving parts of the market to ever higher valuations.
“The ‘story-telling’ narrative has blown away any valuation boundaries with retail, quantitative and passive investors all crowding into the same stocks; leading to unsustainable price formation.
“In other words, the price had become a strong factor in investors pilling into certain parts of the market, ignoring valuations. As a result, we think the valuations of many growth, high return and ‘concept’ stocks are excessive and it is hard to see how the fundamentals justify such a wide valuation discrepancy”.
Halle says the current correction is likely to be shocking for many trend-following investors, and the pain of this experience could finally break the cycle of indiscriminate buying we have seen.
“After the big falls among concept and growth stocks, and with tighter monetary policies likely this year, we could well see investors starting to ask what price they should be paying for highly valued businesses in many different areas.
He adds: “We have long argued that the valuations of growth stocks were excessive and value would return to favour – in mid-2020 we suggested that the 2020s could well be the decade of the ‘cheap asset’.
“It has taken until now and the prospect of rate hikes to prompt a change of sentiment. As the era of cheap money seems to be coming to an end, we feel even more comfortable with our assessment of the environment in this decade”.
Halle suggests investors will pay greater attention to fundamentals and will pay attention to valuation anchors. This will be the most favourable development for out-of-favour value stocks.
Time for small caps?
Rather than looking specifically at value or growth Dale Robertson, fund manager of European equities with Chelverton Investment Management, thinks market cap is a factor right now.
“All the excitement is in small and micro caps and bear in mind that 70% of the companies in Europe are small and micro caps.” Robertson is keen to point out that the analyst coverage is inadequate in this area – with 16 analysts covering every large cap compared to four covering small caps and two covering micro caps.
“You can get good tech exposure in Europe in the small cap area of the market. We are very positive on IT services sector – 29% of our fund is there now. Digital transformation is very much a theme for us – IT service companies helping healthcare, telecoms, banks update their IT systems”.
He namechecks Intofel as a good example of what he is looking for. “Intofel is working with large corporates in France, such as BNP and Airbus, helping them with app development. The company is growing at a very good rate”.