In the past ten years, growth stocks such as those of technology companies have risen more strongly than the overall market. This has led to a significant increase in their weighting in the portfolios of many clients and in indices such as the MSCI USA. Especially during the Corona pandemic, tech stocks and so-called pandemic stocks, such as those of delivery service companies or communication software providers, were able to make gains. But since last year, the momentum for growth stocks has already weakened. That is why it makes sense to take a closer look at growth and value investing.
What actually distinguishes growth stocks and what, in contrast, are value stocks? Value investing aims to identify undervalued shares of companies with stable profits, above-average profitability and a good market position. Growth investing, on the other hand, is focused on shares of companies in the rapidly expanding markets of the future, such as those currently found in the tech sector or in the hydrogen industry.
Gross return of selected US indices in different time periods (in US dollars)
For the full year 2021, for example, the MSCI US Growth Index had a gross return of 26.2 per cent, while the MSCI US Enhanced Value Index gained 29.2 per cent. In the disappointing first eight months of 2022, US value stocks also lost less value overall at 14.3 per cent compared to US growth stocks at 24.5 per cent. The broad market, such as the MSCI US index, returned 27.0 per cent last year and lost 17.1 per cent to August 2022. The revival of value stocks has already happened, and there is much to suggest that their good form will continue even in times of high inflation and restrictive monetary policies by central banks.
Monetary stability is one of the main tasks of central banks. The US Federal Reserve (Fed) ended its multi-year expansionary monetary policy in 2022 due to the rapid rise in inflation, and has already raised its key interest rate with several interest rate hikes in order to curb inflation. What does this mean for growth stocks?
The theory: Rising interest rates cause problems for many growth companies in particular, as they have to take out more expensive loans than before to finance their growth plans. This creates a drag on future profits which is a problem for growth companies given that investors place the bulk of their perceived value in their future earnings. In addition, companies with established distribution channels and high brand recognition tend to be better able to pass on price increases due to higher manufacturing costs to their customers. If these companies have pricing power, margins remain stable or even increase. Good value companies are characterised by their ability to generate reliably high returns even in uncertain times. Against this background, many growth stocks and especially tech stocks underwent a significant correction in 2022. Rising key interest rates can therefore have a greater impact on growth companies and make their shares less attractive compared to value stocks. But that is only part of the explanation.
Results from studies by Erasmus University in Rotterdam and the fund company Robeco show that value stocks in the US have outperformed growth stocks on average since 1866, regardless of whether inflation was low, moderate or rather high. In years with an inflation rate of over four percent, their performance was particularly superior.
Annual excess return of value versus growth shares in percentage points
What is important about value stocks? Warren Buffett has become a stock market legend thanks to his value strategy. He prefers company growth to be achieved through equity capital and not through debt capital in the form of loans. Low debt, high equity and sustained positive cash flow of the company are - apart from the intrinsic value of a share - the key factors of his stock selection and also of American and European value indices. Positive cash flow occurs when a company's revenues are higher than its expenses. And of course, value companies not only reinvest their profits, they also distribute them in the form of dividends, thus giving their investors a more stable return.
Finding well priced value companies that meet certain criteria and have a strong market position requires a lot of effort. Typical selection criteria are the price-to-book ratio, expected earnings over the next twelve months and the dividend yield.
Instead of analysing individual stocks yourself and adding them to the portfolio, the value investing approach can be implemented systematically with an ETF portfolio. Scalable Capital offers the Value 100 portfolio in its digital asset management for German clients and numerous value ETFs in Scalable Broker available in all markets. The Value 100 portfolio is made up of three value ETFs. Due to the way these ETFs are constructed, a stock selection based on value ratios is continuously pursued. The funds are broadly diversified and invested in the USA, Europe and emerging markets. If the key metrics of the companies change, the composition of the indices and thus of the ETFs adjusts accordingly.
Current investment universe of the value strategy
The criteria of the value indices for stock selection lead to a significantly different allocation than for broad market indices. For example, the MSCI USA Enhanced Value contains 150 stocks instead of the 627 in the MSCI USA. The following table illustrates how large the difference in composition and weighting can be.
Top positions in MSCI USA Enhanced Value and MSCI USA
This deviating weighting can reduce risks due to excessive valuations of already hot growth stocks and thematic trends. For example, the MSCI World Index, which is popular with investors, currently contains some growth stocks that are valued at several times their turnover, such as Tesla (12.6 times) or Nvidia (12.7 times). The car manufacturer Tesla was founded in 2003, but it was not until 2020 that the company achieved its first profits. Despite solid margins in the meantime, the valuation is essentially fed by future growth expectations. If these fall across the board, the correction experienced by growth stocks in the first half of 2022 may continue.
With continued success, growth companies tend to evolve into value companies. Those who buy value shares buy securities of companies that have established themselves in their market. Even if their main growth phase is over and thus their price expectations have been realised, regular dividend payments ensure stable earnings from solid business models.
Conclusion: Those who buy growth stocks buy expectations. Those who buy value stocks buy expectations that have been fulfilled. Scalable Capital's value strategy can be used as a core investment to systematically invest globally in fundamentally favourably valued stocks. Whether value stocks will also perform better than growth stocks in the foreseeable future is, of course, not certain.