Growth versus value investing in a COVID-19 world

Growth stocks have powered ahead of value stocks since the Mar. 23 low and are outperforming significantly for the year, whether in the U.S. or globally.

The performance difference in the U.S. is a meaningful 22.5 percentage points. The gap in performance between other developed and emerging country growth and value stocks is also wide, at a non-trivial 16.2 percentage point difference year to date.

U.S. growth stocks have led value by a wide margin

Year-to-date performance of Russell 1000 Growth and Value Indexes

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Russell 1000 Growth (current: 2.8%)

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Russell 1000 Value (current: -19.7%)

Source – RBC Wealth Management, Bloomberg; data through 5/20/20

The reality is, value has lagged for a long time. It has had a few periods of brief outperformance in the U.S. and elsewhere since the Great Recession ended a little more than a decade ago, but overall it has trailed growth badly. Since the beginning of 2010, the U.S. Russell 1000 Growth Index has risen 264 percent, while the companion Value Index has risen only 91 percent.

This is largely due to the significant outperformance of technology-related and Consumer Discretionary stocks, which are in the growth category, and the significant underperformance of Energy and Financials, which are key components of the value category.

But there have been prior periods in history when value meaningfully outperformed growth. Might the style trade shift back to value soon? While there are reasons to pay closer attention to value stocks and we would caution against being outright bearish on them, we doubt value will grab the leadership mantle on a sustained basis over the medium term.

The values of value

Value has the valuation advantage over growth—the category is cheaper, the degree to which depends on the measure.

Based on RBC Capital Markets’ valuation model that incorporates 34 different metrics—this method goes well beyond typical price-to-earnings (P/E) comparisons—growth no longer has the valuation appeal that it did throughout most of the post-financial crisis period. But the value category’s valuation discount compared to growth isn’t nearly as deep as it was during the peak of the tech bubble in 2000 when growth was severely overvalued. This is also the case on a straight P/E basis.

A contrarian argument can be made for value. Given the 10-year+ stretch of underperformance, including the extreme underperformance that has occurred since late 2019, that streak seems bound to change at some point. Value is the out-of-favor style category, and the market can reward an out-of-favor, contrarian view when it is least expected.

Value outperformance has been fleeting

Performance of U.S. Russell 1000 Value Index versus Growth Index

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Ratio of large-cap value divided by growth

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Value outperforms growth when the line trends higher

Source – RBC Wealth Management, Bloomberg; data through 5/20/20

The baton should remain with growth

While we think a case can be made for a brief snapback for value, it’s difficult to envision value totally upending growth over the medium term.

Value needs some economic indicators to shift in order to regain solid footing, particularly inflation expectations.

Since 2014, value has drifted lower as inflation expectations measured by the U.S. Treasury market have declined. Until inflation expectations stabilize and then begin to turn higher on a sustained basis, we think this will be a headwind for value.

Value stocks have drifted lower with inflation expectations

Global value stocks versus inflation expectations

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Long/short global value stocks (left axis)

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U.S. inflation expectations (right axis)

Periods of sluggish or uneven economic output tend to favor growth over value. When economic and corporate earnings growth are scarce, inconsistent, or in doubt, institutional investors tend to reach for secular growth stocks. These are companies that can grow consistently due to long-term positive industry tailwinds, regardless of swings in economic output.

COVID-19 has absolutely ushered in a period of heightened economic and earnings uncertainty. RBC Capital Markets, LLC Head of U.S. Equity Strategy Lori Calvasina wrote, “We suspect that once the U.S. moves past an initial economic inflection that sluggish economic growth will become the norm for a while. And that’s a backdrop that favors Growth leadership.”

Recent U.S. earnings revision trends—the proportion of upside revisions—slightly favor growth over value, according to Calvasina. Profit margins have remained elevated for growth, while they have slipped for value.

Furthermore, money flows are a consideration. Bloomberg Intelligence analysts estimate that $5.8 billion has flowed into value exchange-traded funds (ETFs) globally in the past two months. That’s a meaningful amount, but nearly $8 billion flowed into growth ETFs on a global basis during the same period. Roughly $5.8 billion of that occurred in just the past month, the most in history, when equity markets rallied forcefully across regions. Bloomberg Intelligence views this as a signal that investors may expect growth to continue to outperform value.

Not at a pivot point

As tempting as the valuation and performance differences are, which make the case for at least a brief snapback in value, we think it’s too soon to go big into value at the expense of growth.

Calvasina remains neutral when it comes to this style debate. Each category has positives and negatives and, therefore, she would not meaningfully overweight one at the expense of the other in equity portfolios.