Why quality is crucial in the debate around growth and value
Why quality is crucial in the debate around growth and value
When it comes to investing, “risk” is often defined as volatility. In fact, the biggest risk is making the wrong asset allocation decisions, or being on the wrong side of long-term trends. There’s been much discussion recently about bubbles emerging in certain parts of the stock market, but perhaps not enough about potentially the biggest bubble of all: the valuation of equity markets more broadly.
Digging deeper into equity markets, value and quality are the most dominant factors in the long run. Consideration of these two factors together paints a more nuanced picture for investors than overall market analysis might suggest.
Are equities due a correction?
The US equity market has dominated over the past decade since the global financial crisis and that’s been justified by stronger earnings growth and superior profitability. Clearly the question is how much is already in the price.
The table below suggests that nothing is cheap right now. The table shows various measures of market valuation relative to their history. The first column is the cyclically adjusted price-to-earnings (CAPE) ratio – this uses 10-year earnings in the denominator to smooth out the impact of the cycle and is the best way to compare equities and their potential performance.
A CAPE of 36 for the US market is as high as any time in more than a century other than the dotcom bubble of the late 1990s. But it’s not just the US – all equity markets are expensive, with perhaps only the UK and Japan offering some degree of relative value.
In practice, this means that equities are vulnerable to a correction.
However, the main point is that it’s very likely volatility will be higher in the years to come than was the case in the period leading up to the pandemic. It also means that the US market is the most vulnerable.
Are we at a turning point?
One potential catalyst for both rotation within the equity market and a broader market correction is the potential for inflation to return and the impact that has on bond yields. We’ve grown used to declining bond yields over the past four decades but we do now appear to be at a turning point.
We are in a situation where both cost-push and demand-pull factors are likely to lead to upward pressure on inflation. This is something to keep a close eye on in the months ahead, particularly from the perspective of how policymakers will respond.
Is the stage set for value’s outperformance?
It has clearly been a growth market for the best part of the past decade. Various justifications for this include the low level of bond yields, which boosts the attractiveness of future earnings, and the de-rating of traditional value areas such as financials and resources following the global financial crisis. Clearly, the pandemic was another shot in the arm for growth stocks as many of them were stay-at-home beneficiaries.
Now though, from a cyclical point of view, it would seem a good time to get into value as cheap stocks do tend to outperform around turning points in the growth cycle. The chart below plots the average performance of value versus growth in the US when the cycle turns.
Value comes in many flavours
There are different flavours of value, and quality is another factor to bring into the mix. Value captures terms such as earnings and cashflows while quality can be characterized by stable profitability, financial strength (i.e. not leveraged), good governance and solid growth prospects.
The past few years, and 2020 in particular, have been highly unusual in that it has been the expensive stocks that have outperformed, regardless of their quality. This is changing and value has bounced back since November 2020.
So far, quality value stocks have not enjoyed the same focus, mainly because many of these stocks are more defensive and the market has preferred those with the greatest economic sensitivity.
What does this mean for future returns?
Now that we’ve had the initial rebound in the most oversold cheap stocks, a more attractive part of the market today may be these more defensive value stocks. Taking pharmaceuticals as an example, they are trading at their cheapest multiple relative to the market in at least three decades. Political risk relating to drug price regulation would appear to be more than in the price.
We think the growth prospects for quality value stocks are more compelling than for the average value stock, while their valuations are more attractive than the average quality stock. Based on our analysis, the expected relative return for quality at a reasonable price stocks could be almost 8% annualized over the next three years (assuming a normalization of forward price-to-earnings multiples over the next three years. There is no guarantee this will be realised).
Tactically, given that there is still so much uncertainty about the broader market as well as the pace of economic recovery after the current rebound, it could also make sense to be more hedged on value exposure by dialling up the quality. These stocks have a greater propensity to perform across a broader range of market and economic scenarios.
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