With growth stocks crushing value stocks over the past few years, we’re often asked, “What will it take for value stocks to outperform?” Two key, but often overlooked, considerations are interest rates and the math behind discounting future cash flows in a net present value (NPV) calculation.
Growth stocks are long-duration assets. These companies will typically reinvest their margins into growth initiatives, reducing near-term cash flows until later in their life cycle. In contrast, value stocks are shorter-duration assets. These companies are typically more mature and allow a greater percentage of margin dollars to drop to the bottom line. This difference in cash-flow patterns has a meaningful impact on the present-value calculation of future cash flows (in other words, the value of the company today).
Falling 10-year Treasury yields over the better part of the past decade have produced a significant tailwind for growth equities. However, if long-term rates were to move higher, the tailwinds would turn toward shorter-duration value stocks. Fixed-income investors are well versed in shortening portfolio duration as rates are rising, but this is equally important in equity investing.
We don’t claim to be experts in forecasting the direction of interest rates or the timing of when equity markets will discount a change in the direction of rates, but we do see a couple of developments that could prove to be constructive for real long-term rates to move higher.
1. We believe a more broad-based and more robust, post-COVID-19 economic recovery would likely cause the gap between growth and value multiples to converge. Growth in gross domestic product (GDP) since the 2008 recession has been lackluster and narrow based. A post-COVID-19, global economic recovery could spark the GDP growth velocity that the more cyclical value stocks have been needing. In this rather mundane economy, sustainable growth has been scarce. This scarcity of growth has allowed companies that can generate their own idiosyncratic growth to command much higher multiples than companies that require a rising cyclical tide. As investors have begun to discount a vaccine’s impact and the potential for explosive economic growth on the other side of the crisis, cyclically exposed value stocks are likely to be among the largest beneficiaries.
P/E is the price of a share of a stock divided by earnings per share, usually calculated using the latest year’s earnings.
2. Inflation also has been lacking for the better part of the past decade. Since the era of former Federal Reserve (Fed) Chair Paul Volcker in the early 1980s, the Federal Open Market Committee has operated under a dual mandate of maximizing employment while keeping prices stable. Any time the Consumer Price Index indicated inflation was approaching 2%, the Fed would “tap the breaks” by moving short-term rates higher. However, Chairman Powell stated in his Jackson Hole, Wyoming, speech in August that the Fed would now allow inflation to run moderately above the stated 2% goal “for some time” following periods when it has run below that objective. This is a very monumental change in monetary policy that could have a significant impact on long-term real rates and on value companies’ ability to obtain much-needed pricing power.
The combination of a backdrop of fiscal and monetary support for the economy following a successful vaccination effort can be reasonably expected to broaden and accelerate economic growth. We believe this should reduce the premium paid for the currently scarce, idiosyncratic growth companies that dominate financial press headlines relative to the companies comprising the value-tilted indices. With the Fed on hold for the foreseeable future, the proverbial gas pedal will be to the metal—and value stocks, in our view, have a strong chance to regain their long-term status of outperformance over growth.
Timing market rotations is very difficult to do, and investors have been reminded of this repeatedly in 2020. We don’t claim to have a unique ability to time these leadership changes, but we do believe asset allocators could benefit from a reminder on how interest rates affect equities and what that could mean for the growth versus value debate.
Asset allocation does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.