Go for growth or value in the equity space?

Growth

Bill McQuaker Head of Multi-Asset at Henderson Global Investors

Bill McQuaker, Henderson

I am going to be a tease here and argue that growth and value are two sides of the same coin. I have lost count of the number of companies and sectors that are first viewed as growth and then migrate to value and vice versa. Of equal difficulty is finding a coherent definition of the two terms. A simple definition might be that value exists when the intrinsic worth of a company is not currently recognised by the market while growth exists when the future worth of a company is not recognised.

Warren Buffett once said of growth and value in the 1992 Berkshire Hathaway Annual Report: “In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value.” It is difficult to disagree with this portrayal but by the same token, just as we might favour a sub-sector of a sector, so there are periods when growth, a subset of value, looks attractive.

We are living in a growth-starved world, at least in developed markets. It is still possible to achieve attractive levels of growth in emerging markets and Asia but we must make the distinction between economic and earnings growth. China has been excellent at growing its GDP but this has not always translated into profitable companies and rising share prices because excessive capital spending and overcapacity has often destroyed margins. We think it is important to invest in funds that have a strong track record of isolating companies in fast-growing markets that can demonstrate strong returns on equity. For that reason, we like funds such as First State Asia Pacific Leaders.

In developed markets, the corporate sector has been quite adept at raising its level of profitability at a time when domestic economies have been relatively weak. In fact, a common refrain is that companies are being overly conservative with spending and building up unnecessarily high cash levels. Investors are prepared to pay up for earnings growth, however, and we see this in the premium placed on some companies. For example, ARM, the UK chip designer behind many of the chips in smart phones, was trading on 541 times earnings at the end of 2012.

This might seem like a rich valuation but it is worth considering that back in December 2003, it was trading on an even higher multiple of 751 times earnings. Value investors would not have touched the stock at that time at such an elevated P/E ratio but in doing so they would have missed out on a total return of 556 per cent over the following years to 31 December 2012. We favour funds such as the Henderson Global Growth Fund that have a track record in identifying companies with strong earnings growth and sales momentum.

Looking at the MSCI World Value and MSCI World Growth indices over the past 10 years to 31 December 2012, value outperformed in the first five-year period (growth +68.6 per cent, value +93.9 per cent) but growth has done better in the more recent five-year period (growth +23.1 per cent, value +14.3 per cent). This might reflect some of the structural shift that has occurred in economies in recent years. For example, telecoms, long seen as a value sector, has underperformed because there has been structural pressure on margins as penetration growth rates have tailed off and regulators have capped charges. Value, in this sense, has displayed the feared characteristic of a “value trap” in which a stock trades on a cheap valuation because it has gone ex-growth or there is no catalyst to alter sentiment towards the stock.

Investors need to be careful, therefore, not to confuse value with stagnation. In contrast, growth stocks, by definition, are more likely to have secular growth characteristics that allow them to expand even as the economy is weak. With the economies of the developed world expected to remain fragile over the near term, it would not be surprising if investors continue to pay up for growth.

However, all is not lost for value investors: in Europe, valuation extremes are more prevalent and that may make for easier pickings for value-orientated investors.

Value

Florent Bronès

CIO, BNP Paribas Wealth Management

Why should we see a risk premium compression in 2013? We believe the US will  limit the impact of the fiscal cliff, so we expect solid growth. Meanwhile China’s economy is softly landing and even on the way to a new take-off, with positive implications for Asia.

Europe has developed political and monetary instruments to prevent a liquidity crisis in the big countries of the periphery. A permanent help mechanism was established with the creation of the European Stability Mechanism (ESM). The combined resources of the ESM and the temporary fund European Financial Stability Facility enable the eurozone to tackle the problems of bigger countries like Italy and Spain. The launching of a European bank union will transfer the charges related to the recapitalisation of local banks directly to Europe.

The plans developed by ECB president Mario Draghi, the so-called OMT, give the ECB the freedom to intervene and fight liquidity crises in the European periphery.

As a result, tail risks are declining, paving the way for lower risk premia, from the current very high levels. This should be an advantage for risk-related assets, and in the first place equities. As Europe suffered most from fears of systemic risk, it should benefit most from the weakening of these risks. We overweight European equity markets. Peripheral corporate bonds are also well placed to take advantage.

The declining risk premium should also influence stock preferences. Over the last few years, defensive growth stocks have dominated the scene. Other stocks were considered as too risky and were suffering from the weak global economy. As a result, their prices fell to extremely cheap levels. When risk aversion diminishes, these stocks should benefit from their battered valuations. In relative terms, value stocks will outperform.

This rising appetite for risk should also affect choices in the equity universe. Battered valuations will become a real advantage for the stocks concerned. The cyclical adjusted price to earnings ratio is at a historical low in Europe and some opportunities are thus expected to emerge through 2013.

In this perspective, we favour value stocks to growth ones. Value and growth stocks are two different investment styles. The latter favours companies with strong growth potential and the former looks for opportunities in compelling stocks based on key financial ratios and valuation criteria.

In recent years, investors have favoured high-quality companies with growth prospects, which were not overly affected by local difficulties thanks to their global brand and pricing power. Growth stocks have been the best performers in Europe over the last three years, and over the last six years in the US. Value stocks outperformed growth only between 2003 and 2006 when stockmarkets rallied globally. Since then, growth has outperformed because of bear markets and/or slowing global growth. We expect the reverse in the coming years.

Value stocks are largely present in telecoms, utilities, energy and financials. However, some of these sectors, such as telecoms and utilities, look attractive based on those criteria but offer little upside. We are aware of the ‘value trap’ risk. We thus recommend being selective and focusing on other sectors.

Domestic European stocks will continue to be impacted by the weak local economy. We favour the internationalised parts of the equity markets which are sensitive to the accelerating global economy.