All investment styles go in and out of favor, sometimes unpredictably. After well over a decade of good returns from growth stocks, some investors believe that value investing is due for a resurgence. Typically, when growth investing is doing well, value investing is underperforming and vice versa. A distinction between value and growth investing isn’t as clear as some might claim. A sustainable growth business that is trading at a reasonable valuation is also a good value stock—value and growth investing are tied at the hip.
However, there are a number of reasons why growth strategies could stay on top. For one, the U.S. equity market has become narrower and strength has consolidated around higher quality businesses. There are more opportunities residing in the growth camp—businesses that have sustainable, predictable growth, strong competitive advantages, strong structural drivers with good visibility and are trading at reasonable valuations. The challenge is to assess whether or not they retain their competitive advantages, or if they are being eroded. In my experience, many leading companies actually continue to reinforce their competitive advantages over time. Therefore, investors can compound returns with the earnings growth of the business.
Traditional value investing focuses on businesses that are trading at a discount. Consider the example of a business that is trading at half of its book value. It seems reasonable to expect that it will narrow the discount, and that book value could also increase. However, such businesses are less likely to compound earnings because they are frequently low growth and/or cyclical. Investors will probably be waiting for a catalyst to close that valuation gap—which could take a long time. Further, even if the valuation gap closes, the investor then has to recycle that capital into a new idea.
That’s not to say that value strategies cannot do well—the value approach has given short periods of outperformance in the last five years. Those periods tend to be when the market becomes very positive and bolstered by stimulus, creating a tailwind for value stocks. But those windows are increasingly short and it’s a hard approach to get consistently right. The counterpoint is consistent outperformance from growth strategies predicated on long-term drivers.
Understanding Risks, Unearthing Opportunities
Last August, the US equity market reached a milestone—its performance marked one of the longest bull runs in history. Some 400 days later, the record period of growth continues. Today’s investors know that unbroken runs must come to an end at some point, they just don’t know when.
There are still plenty of reasons for investors in U.S. equities to be positive. Economic growth in the U.S. remains solid, jobs are being created, wages are rising, and monetary and fiscal policy has been watchful and supportive. But there are also plenty of causes for concern. The trade war between the U.S. and China rumbles on, global geopolitical tensions are high, and looming Presidential elections will raise debates about regulation in sectors including technology and health care.
It is impossible to know precisely where we are currently in the economic cycle. Expansions do not have set expiry dates, although excesses often build the longer they continue, sowing the seeds of the next recession. There are signs of dislocation that indicate we are later rather than earlier—the huge volumes of global bonds held at negative yields for one. But without the ability to predict with certainty when the cycle will turn, investors should focus on ensuring that their portfolios are positioned to weather any storm that may come.
Opportunities Amid Risk And Volatility
The current market expansion has not been without its shocks. The volatility of the fourth quarter of 2018 was one of the toughest for some time and served as a reminder that stock selection is critical. Investors can look for potential high-quality companies with stable earnings growth, particularly in the consumer discretionary, consumer staples and communications services sectors. And, despite the concerns around regulation in the upcoming election year, investors can also look to select large-cap technology and health care companies with well-established, resilient business models.