22/05/06
Growth v Value
With the current strength of stock markets, combined with a positive outlook, it is no surprise that investors are returning to equity markets. The choice for their advisers is whether they should recommend funds that are predominantly growth or value orientated.
Growth stocks tend to trade on a high price/earnings (P/E) ratio, price-to-book, price-to-sales ratios, together with low dividend yields and are what is often referred to as high beta. This means that they move up and down more strongly than the market.
By contrast, value stocks generally trade on lower P/E multiples, price to book and price to sales ratios. Value investors generally purchase stocks at relatively low prices in the hope that the underlying strength of the business will enable the share price to increase over time. Companies that fall within this category are often from the more economically sensitive areas of the market such as chemicals, engineering or building materials. It is also common for them to provide an above average dividend yield, which is regarded by investors as compensation for the poorer growth prospects.
Backward looking research covering the last century shows that value stocks have been the better performers for investors with a longer term time horizon although the same research shows that there may be sharp variations in performance of the two from year to year.
The last period of strong performance among growth stocks came during the 1990s. The final stage of this period of growth was epitomised by the TMT bubble that continued to grow as investors pursued the spectacular rises that were being generated by the stocks of all companies that were related to the internet. The inevitable bursting of that particular bubble in 2000 marked the transfer of the position of supremacy from growth to value stocks.
The subsequent five year period produced stronger performance among value stocks, a pattern that was beneficial for income orientated fund managers at the expense of those managers with a bias towards growth stocks.
This bias that has also been supported to a large extent by global economic factors. The P/E valuations of growth stocks peaked several years ago, around the time the technology bubble burst and have subsequently underperformed. However, recent changes to the global picture mean that the decision is now less clear cut than it was previously.
A steadying of the rate of growth in most of the major economies around the world, interest rates that are now on an upward trend but may be close to peaking, high commodity prices and signs of weakness in consumer spending all point towards a dip in the level of growth in corporate profits, which nevertheless will remain on an upward trend. Another signal that has historically been the prompt for a move towards growth has been a flat or inverted yield curve, such as we are currently seeing. In addition, interest rate and inflationary pressures are set to remain subdued.
Therefore, many market commentators believe that the climate appears ripe for growth stocks to return to favour. Many investors also took this view at the start of 2005 and positioned themselves accordingly. In the event, this proved to be a false move in the majority of cases as neither growth nor value clearly triumphed over the year as a whole. However, in the course of the year, both styles had periods of outperformance, with value stocks eventually coming out marginally on top overall.
At present the strength of the value versus growth argument differs across the various UK markets. For example, within the small cap universe, there is little to tilt the debate one way or the other. However, in mid-caps, growth stocks are now performing better than value and this is also true of the large-cap arena. The move may also be attributable to the momentum being generated by speculative investors.
In terms of rewarding investors, the current economic and market environment should allow companies to continue to make generous dividend payments. We expect to see dividend growth of around 10% for 2006 as a whole. It is this, combined with strong earnings, attractive valuations, dividend growth and an increase in bid activity that leads us to believe that the market has been in good shape over the early part of 2006 and should remain so.
As we have seen, there may be arguments to favour either value or growth stocks at any given time. However, neither will be the correct option for all investors at all times because, as Warren Buffett once claimed, the two styles are "joined at the hip."
The accuracy of this assertion has been underlined by apparent crossover between growth and value equities over the last few years. So, a stock that would fit squarely into the growth camp, has adopted some of the qualities of a value stock and vice-versa. A prime example of this phenomenon is Vodafone, which was broadly regarded by investors as a growth stock with all of the traditional characteristics such as the potential for double-digit gains but more recently has begun to behave like a utility with little growth but a high dividend payout.
In our view, therefore, the growth versus value argument is irrelevant and pointless. We believe that there are many other factors that play a part in the process of stock picking. At Standard life Investments, the basic investment philosophy, which we refer to as Focus on Change, remains the same, regardless of whether the mandate we are running is growth or income.
Our objective is to identify undervalued companies where the outlook is improving ahead of current market expectations. This can only be achieved by ensuring our investment thinking is well ahead of the general view. In order to do this, we adopt a multi-dimensional approach.
This approach recognises that different factors drive markets at different stages of the investment cycle. Rather than focus on the growth versus value argument, we look at the most important factors which drive the price of a share then focus on what is changing and why it will impact on the price. We believe that this approach offers considerably greater prospects for consistent strong returns than either growth or value investing, which will inevitably both underperform at some stage of the economic cycle.
In the future, there is likely to be less difference in performance between growth and value funds. The main reason for this is P/E ratios across the market have compressed. A few years ago for example, Vodafone traded at a P/E of approximately 50X while a so-called value stock like BAT traded on a P/E of approximately 8X. Now they both trade on 12-13X. Therefore the relative performance of growth and income funds is likely to be more aligned than has previously been the case.
We believe it is more important to focus on what is changing at a stock level rather than relying on any specific market trend.
Investors who were around at the time of the TMT experience will understand the importance of an approach that focuses on what is changing for a stock - whether growth or value - rather than relying on any specific market trend.
Karen Robertson, Manager UK Equity Growth Fund and UK Equity High Income Fund, Standard Life Investments
This article was first published in Investment Adviser on 22 May
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
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