Growth Stocks Will Outperform Value Stocks For The Foreseeable Future

by: Foundational Research

Summary

Investors should remember that growth companies actually have higher quality earnings and lower operating leverage, rather than the popular misconception that they embody speculation and waste.

Value indexes are often heavily populated by companies with high fixed costs and operating in cyclical sectors.

There is a high probability of a sustained outperformance in growth companies when compared to value companies.

Equity market indexes have rallied to new highs following the October Volatility. The resurgence is masking a number of pronounced sub-surface shifts. Large caps are beating small caps, Defensive stocks are outperforming Cyclicals, services-oriented firms are rising compared with goods producing ones, and growth stocks are reasserting their leadership role versus value shares. The fundamental and market forces that drive the performance of growth and value stocks is the topic of this article.

Historically, growth shares outperform value stocks when equity markets are in a secular bull market and vice versa. The sense is that the U.S. stock market is in a cyclical overshoot phase and is vulnerable to a pullback; thought is that U.S. stocks are still in a secular bull market established in the aftermath of the great recession. The upshot is that an important long-term tailwind exists for the growth style bias.

Growth stocks tend to outperform, when the NASDAQ composite outstrips other broad market averages. The NASDAQ-to-DJIA ratio has done an excellent job gauging major turning points in the style cycle because the NASDAQ is more geared to high-growth dynamic firms. The current uptrend in the NASDAQ-to-DJIA ratio indicates that the path of least resistance remains up for growth stocks.

The long-term equity market trend is not the sole factor supporting growth stocks. Increased investor appetite for growth stocks is influenced by a downshift in global economic growth, driven by the forces of deleveraging. The European Union's economy is on the edge of yet another recession with consumer prices flirting with deflation. Emerging market growth has disappointed this year, led by weakness in multiple large emerging market names. While policymakers in Japan, China and the European Union have finally begun to ratchet up their stimulus efforts, there is little evidence that this will amount to a sustained increase in final demand. Policymakers are playing catch-up with intensifying deflationary pressures because inflation expectations remain dangerously low. In a world riddled with too much debt and too little growth, lowering borrowing costs only buys time rather than generating expansion. Stimulus efforts are more likely to redistribute growth to regions experiencing currency weakness rather than increase overall global economic activity. The implication is that economic growth is becoming increasingly scarce - an environment that is ironically beneficial for growth equities.

The inverse link between value versus growth stocks and global leading economic indicators is not just a function of investor preference. It also reflects the trend in relative profit drivers. For instance, our pricing power proxies for the growth versus value indexes are heavily skewed in favor of growth. This lopsided pricing power is fueling top-line outperformance for growth. The relative sales-per-share ratio has just started to rebound and there is further upside potential before it attains its post-recovery highs.

Growth companies generate consistently higher profit margins than value firms. A comparatively higher economic beta implies weaker sales prospects for value indexes. Consequently, the current profit margin gap could widen even more in the coming 12-18 months. Despite a brighter sales outlook and better profitability, growth stocks are not expensive in relative terms. In fact the relative price-to-sales ratio is slightly below its long-term average.

The amount of risk shedding in a number of asset classes throughout the world highlights concerns about the sustainability of global economic growth and the Federal Reserve edging closer to monetary policy normalization as the rest of the world steps up its reflationary efforts, causing wild currency-market gyrations. This environment is inherently more risky for financial assets because the markets are overly reliant on liquidity conditions due to insufficient aggregate final demand and excess savings. Uncertainty about the balance of global liquidity will spawn future higher equity market volatility.

Historically, as volatility has escalated growth stocks have surpassed value stocks because they have a more defensive bias than their value counterparts. Thus, the next few years should become more growth-style friendly. There are signs that investors are already retreating into higher quality and defensive sectors and groups. This is consistent with the recent widening in corporate bond spreads, which may be an indication of the receding appetite for risk and the deflationary side-effects of the robust U.S. dollar.

Similar to any other index, performance of growth and value indexes track the returns delivered by their constituents. The growth composition is heavily weighted in information technology (28% of the total market cap) and health care (17%).

Value indexes are less geared to health care and technology (11% and 10% respectively), but have nearly triple the energy sector weighting (14% versus 5% for growth). A bear market in oil prices amidst a global economic slowdown is undermining the energy sector's returns, exacting a heavy toll on the relative performance of value stocks. These divergent sector profiles imply that growth indexes possess natural hedges against weak global growth and deflationary pressure.

Continued United States dollar appreciation could become a headwind, to the extent that it undermines foreign profits. Historically, growth stocks have trailed value stocks when the United States dollar is strong because the growth indexes have larger exposure to globally exposed sectors such as technology, industrials and materials. Meanwhile, large weightings in the financial sector define the performance of the value indexes. A stronger U.S. dollar used to be negative for the growth to value relative sales ratio. However, this correlation has reversed since the great recession.

Earnings typically contract during recessions. Cyclical spending in the U.S. as a percentage of GDP is currently hovering around levels comparable to previous recessionary lows, implying that pent-up demand has yet to be fully exhausted. Deleveraging is advanced in the U.S., the labor market is healing quickly and loan growth is accelerating. All these factors underscore that the odds of an economic relapse are low, barring a major exogenous shock such as a Chinese hard landing or a rekindling of the euro area debt crisis.

After several years of lateral relative performance, growth stocks are on the verge of breaking out to new cyclical highs versus value stocks. Disappointing global growth, combined with weak commodity prices, declining investor appetite for risk, and favorable pricing power all suggest that a valuation re-rating will occur. Investors should establish or retain a growth versus value bias for the foreseeable future.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.