Stock markets have been fairly quiet in recent days, moving higher most of the time. But underneath, a spectacular rotation has been going on. Value stocks – which have lagged growth stocks for almost 15 years (see also the chart below) – have beaten growth stocks by a wide margin. But is this a signal that the ‘great rotation’ has begun?
Value outperforms growth
Despite having underperformed in the past decade and a half, value stocks have outperformed growth stocks since 1975. A key explanation for this long-term trend is that investors tend to be overly negative about dull, slow-growing value stocks and are generally too enthusiastic about growth stocks, which seem to offer limitless potential.
This extrapolation of future expectations has to be adjusted at some stage, at which point value will outperform growth. But the fact that this has not happened in the last 15 years suggests that more factors are at play, with the increasing scarcity of growth being one example: global growth had already slowed in the run-up to the financial crisis and waned further once the crisis had erupted.
This could mean that investors are willing to pay more for companies that show high growth levels. In addition, secular trends are almost certainly playing a role. The past two decades have been characterized by enormous technological waves. From advanced production processes to a shift towards online consumption, and the emergence of social networks such as Facebook: they are all driven by technology.
And technology companies are growth companies most of the time. On the other hand, one of the more traditional value sectors – banking – is struggling. The aftermath of the financial crisis, increased regulation and new competition in the form of fast-growing fintech companies (growth stocks) have put the sector under considerable pressure.
Will the rotation continue?
It is hard to tell whether the rotation will continue. Investors are unlikely to stop their habit of extrapolating expectations. This could justify a structural tilt towards value stocks. What is more, value stocks are currently cheap from an historical perspective.
When economic growth picks up, partly as a result of new central bank stimulus, growth will become slightly less scarce. But this doesn’t mean it there’s no case for owning growth stocks. Companies that specifically benefit from secular trends such as technological change, an ageing population, and the changing environment, could definitely outperform the market.
The key, of course, is in selecting those companies that can meet their growth expectations.