by Nick Samuels
Nick Samuels, head of equity manager research at Redington
In this growth-constrained world we have faced in recent years, it is no surprise equity investors have clamoured for high-quality growth stocks. Valuations in this element of the market have been driven up to nosebleed levels, particularly in emerging markets.
As a style, value has massively underperformed growth over the past five years. This length of underperformance has never been seen before. Quality growth stocks are liked for good reasons, but investors must be wary not to pay too much for this. At the moment, most market participants are paying too high a price for quality growth compared to long run averages.
After lagging for so long, value as a style could potentially come back into favour in 2016. As the Federal Reserve looks set to embark on a period of rate rises in the near future, it is interesting to note value has historically performed well during rate hiking periods.
US stocks are stretched, but opportunities exist
Looking at the opportunities available across global equity markets, US valuations appear stretched on almost all metrics. If you need to invest in the US, a value strategy could outperform growth, but if there is no reason to be there, it is best to look elsewhere.
The picture is less clear in emerging markets. Some high quality growth stocks in emerging markets – in the healthcare and consumer staples sector – are trading at valuations greater than many developed market counterparts. Dedicated EM managers have had to hide somewhere during the EM bear market, which has pushed prices up even further in quality growth.
Nowhere is this more evident than in China. As China transitions towards a more domestic-facing economy, consumer-related stocks have been sought out by investors and valuations have climbed significantly. Most market bubbles have had a root in reality. The Tech phenomenon for example was a genuine trend in 1999, but it became significantly overpriced. A similar thing is currently happening in Chinese domestic consumption and Internet names.
The value investment style could start to do well now in emerging markets, in currently unloved areas such as banks or industrials. These clearly do not sound like particularly attractive opportunities, but taking an uncomfortable stance is the whole point of value investing. The spread between the most expensive stocks and the cheapest is at historically wide levels – usually this points to the outperformance of Value as the spread narrows.
The emerging markets are cheap, but it may be too uncomfortable for some, so this could bring Europe and Japan into focus. Expectations are for sluggish global growth for the next year or so, but if growth starts coming through better than expected in Europe, it could lead to a re-rating. It is very difficult to see US equity markets delivering another 10% to 15% return given the valuations, but this cannot be discounted in Europe.
Understand context of returns and be flexible
Should we finally see some sort of rotation out of growth into value, pension funds will have to look at the overall composition of their portfolios. Many of the equity managers that have performed well over the last few years may not necessarily be the managers positioned to outperform over the coming years.
A pure quality growth manager is only ever going to be quality growth. Should we see a style rotation into value, this could result in a prolonged period of underperformance. Therefore, pension funds will need to really understand their managers and the context of their historical returns. It may be the case to say ‘thank you’ and move on.
