07 May 2021
It feels like the investment world is divided into two camps at the moment. Are you a quality/growth investor or a value investor? You’re one or the other, so pick your team. And that’s as true in the UK equities market as anywhere else, right now.
But do investors have to choose? Is there another way ahead from here?
Ever since interest rates plummeted during the global financial crisis, the quality/growth investment approach has benefited from favourable tailwinds. These have only grown more powerful in recent years as Brexit and now the Covid-19 crisis have taken their toll on markets. With interest rates pinned to the floor for so long, pedestrian global economic growth and the threat of economic crises ever-present, companies with significant growth potential have been dramatically re-rated.
All this makes sense of course. However, this kind of logic can lead to bubbles forming if one investment style is in the ascendancy for a long period of time. Those stocks that fall into the quality/growth basket naturally take the lion’s share of flows. This, in turn, reinforces their high valuations, bringing momentum investors on board in those same names.
Meanwhile, value investors have had to contend with the headwind of economic dislocation, which has severely impacted many traditional business models and cyclical industries. This is on top of further dramatic structural changes across a range of industries. For example, the high street moving online, energy providers forced to plot a route to reduce their carbon footprint, among others. To these investors, it’s seemed the market has no regard for traditional valuation metrics like price/earnings, dividend or free-cashflow yield as drivers of returns.
But since news in November 2020 of effective vaccines, and long-term interest rates starting to tick up, the shoe’s been on the other foot. Some of the stock market darlings of the last few years have faltered and seen their ratings pull back. Meanwhile, out-of-favour cyclicals have driven overall market levels higher. So are we seeing a fundamental change of market leadership? Or is this just a blip in a structural trend of outperformance by quality/growth stocks?
We would argue that there’s a third possibility. After a particularly abnormal period in markets, and individual stock valuations stretched to extremes, perhaps this is an inevitable correction before a return to good old-fashioned stock picking.
The economic data and corporate results are likely to support cyclical stocks over coming quarters, as we emerge from this past year’s long economic winter. However, we’re unlikely to see interest rates suddenly bounce back to 5% or anything like it. The factors that have supressed inflation for the last decade are still powerful and there will be long-term effects from the Covid crisis. This means trend growth over the next cycle is unlikely to be much better than during the 2010s.
We expect a less straightforward, more interesting environment for UK equities. One in which neither quality/growth nor value investors get their own way.
The one-way trade for buying quality/growth stocks at any price seems to be over. That approach only worked while interest rate expectations continued to fall and ‘fast’ money didn’t fear a reversal of market momentum. However, that doesn’t necessarily mean that those stocks can’t keep generating attractive returns. If the underlying business performance of those companies drives better-than-average growth and, importantly, better-than-expected growth, they will remain attractive. Upgrades to market expectations will always be a strong driver of returns, whether it’s a highly valued tech business in growing markets or a lowly cyclical benefiting from an economic rebound.
Even in 2020, if you could call the performance of the businesses you invested in, you could outperform without taking sides on the growth/value debate. There was no point being defensively positioned if you owned GlaxoSmithKline, Imperial Brands and Centrica. And, for their own particular reasons, shareholders in Just Eat Takeaway, Boohoo or even AstraZeneca didn’t make the returns due to Covid-19 that they might have expected. However, the stock picker who owned Asos instead of Boohoo, United Utilities instead of Centrica, or a UK housebuilder instead of a large UK property company like Land Securities would have made excellent relative returns. (Companies selected are for illustrative purposes only to demonstrate the investment management style described here and not as an investment recommendation or indication of future performance.)
Through the rest of 2021 and beyond, we expect a less straightforward, more interesting environment for UK equities. One in which neither quality/growth nor value investors get their own way. There will always be room for a high-quality business that is growing well ahead of GDP and beating market expectations to outperform. And there’s space too for traditional value stocks with sustainable business models which can keep generating the cash that underpins their cheap valuations. They’re unlikely to face the continual headwind of ever-lower interest rates, which have held back their relative performance this far.
The investment managers with the most potential to outperform from here will likely be those who avoid betting on one macro view and focus on the micro instead. So, the managers who really know what’s under the bonnet of the companies they hold. Who scrutinise company and industry-level drivers of change and analyse what the market is pricing in at a stock level.
In other words, investment managers who know the companies they own inside and out. And not those who try to ride the stock market trend of the moment.
A version of this article first appeared in The Herald on 3 April 2021.