The Growth vs. Value Stock Debate (2021 Edition)
March 1, 2021
By Michael List,
It is often said that investment management is a science and an art. It’s a science because there are repeatable patterns we can analyze to help predict the future. A company’s earnings, debt ratios, growth rates and cash flow all matter — and help us see where the company is headed.
However, it is also an art because there are factors that do not show up in the current financial numbers that take years to blossom. These factors include brand loyalty or finding a CEO who has that unique drive and charisma that enable them to push the limits and innovate new products or ways to serve their customers.
Yet, the investment world is still more complex, there are external factors that can influence a company’s stock price, like interest rates. Last week was an example of how external factors can move market prices on the short term.
One way to consider the impact is looking at current market price and earnings or P/E. The chart below from Yardeni Research, Inc. shows the breakdown between growth and value:
At the beginning of 2021, growth stocks were trading at a P/E of 30 and value stocks were trading at around 15. Based on those ratios, investors were paying $30 for every $1 of growth a company earned. Said another way, 1/30 of a growth stock’s price is influenced by today’s earnings, while 29/30 is from future earnings. In contrast, 1/15 of a value stock’s price is today’s earnings and 14/15 is future earnings. At these price levels, much more of the growth company’s price is based in the future compared to value stocks. This is where interest rates and inflation come in.
Taking a Closer Look
Here is a hypothetical example to help illustrate how interest rates can affect different types of companies. Let’s say we have two companies: Growth, Inc. and Value, Inc. Based on our research, we expect Growth, Inc. to grow earnings at 11% and Value, Inc. will growth earnings at only 3%. Now, it is reasonable to pay more for Growth, Inc. stock, because future earnings will be much higher; the question is how much more?
If both company’s earn $1 per share today, assuming the above growth rates, in 15 years earnings per share would rise to $4.3 for Growth, Inc. and $1.5 for Value, Inc. Those are earnings that will be in the future, therefore, we need to adjust for inflation to see what those earnings are worth today. With a 1% discount rate, the stream of earnings in current dollars is $31.2 for Growth, Inc. and $17.1 for Value, Inc. But, what if interest rates and inflation are higher? What if the discount rate changes to 3%? Now the stream of earnings in current dollars is $25.9 for Growth, Inc. and $14.6 for Value, Inc. The change in the discount rate has a larger impact on Growth, Inc. And that is what we saw last week, as interest rates on the 10-year Treasury rose to 1.5%; the Dow Jones was down slightly, while the growth heavy NASDAQ fell over 5%.
Rebalancing Your Portfolio
We’ve said in the past, “valuation is not a timing device.” At the beginning of 2020, the growth-versus-value spread was already larger than in the previous 20 years, and it ended the year 50% wider. Valuations are part of the science of investment management and one of the best predictors of future returns. At current valuations, growth stocks are more vulnerable to shocks like rising interest rates or inflation, while value stocks offer attractive prices and higher dividends. During January and February, we have been rebalancing portfolios to reduce equities (after strong returns through the end of 2020) and to trim some of the exposure from growth companies while adding to value companies. We are not eliminating growth for the sake of value; portfolios are still broadly diversified but have a tilt towards value. If you would like to discuss how your portfolio is structured, please reach out to your Advisor.