Nothing goes on for ever in financial markets. The one thing an investor can rely on is the fact that the pendulum will swing back again. The economic cycle, valuations, investment styles - they all come and go, reverting to the mean and overshooting in the other direction. If we could only predict when the turns would happen, it would all be very easy.
It’s not that simple, of course, and more money has been lost mis-timing the tops and bottoms than ever was given up in the downturns. It’s why sensible investors accept the steady plod of time in the market over the more exciting but ultimately costly attempt to time the market.
The pendulum swing that’s exercising the minds of investors at the moment is between the two predominant investment styles - growth and value. Which side of this investing divide you have been on over the past 10 years has pretty much determined how successful your investments have been. The big question today is whether we are witnessing a once in a decade reversal in style. The answer could determine how well your portfolio fares over the next 10 years.
First, let’s define what we mean by value and growth. Growth shares are those companies which can be expected to deliver rising earnings, more or less regardless of what’s going on in the wider economy. They are often businesses selling products or services that we cannot or don’t want to do without - toothpaste, smartphones and booze spring to mind.
Because sales and profits are reliable, investors are prepared to pay a high price for these kinds of shares. They are particularly happy to do so when the outlook for economic growth is poor. Growth shares do well, therefore, when growth is scarce. Confusing, I know.
Value shares, on the other hand, are out-of-favour companies that trade cheaply against their own history and when compared with more modish growth stocks. They are out of favour either because they are experiencing idiosyncratic problems of their own or because the economic environment is against them - or both, of course.
Because they are so unpopular it does not take much of an improvement in the external environment for these kinds of shares to look oversold and attractive to more contrarian investors. Value shares, therefore, do well when the economic backdrop starts to improve or simply stops deteriorating.
The ten years since the financial crisis have not been a good time to be a value investor. The long, slow recovery since 2008 has seen investors gravitating towards the consumer staples and technology shares that have been able to promise earnings growth in this sluggish environment. Growth shares have become ever more expensive while cheap value shares have got cheaper still. The valuation gap between the two has widened to an unprecedented level.
Over the past couple of years that trend has been accentuated by the headwinds blowing through the global economy. The trade war and the Fed’s desire to normalise monetary policy provided the perfect environment (relatively speaking anyway) for growth investors. In the UK it has favoured investors like Nick Train and Terry Smith who placed a big bet (via concentrated portfolios of high-quality growth stocks) on that environment continuing.
Retail investors have poured money into their funds in recent years and they have been well-rewarded for doing so. The Lindsell Train UK Equity Fund, for example, had until very recently been the best-performing of the four fund recommendations I made in these pages towards the end of 2018.
Since the summer, however, there has been a notable reversal in the fortunes of value and growth shares and the funds that invest in them. Value shares have picked up the performance baton as the economic backdrop has started to improve. Business surveys point to a bottoming out of the growth cycle. Corporate earnings have turned out a bit better than expected and look likely to improve further next year. Donald Trump looks like he is starting to prepare for next year’s election with a tactical retreat on the trade front. And the Fed has gifted investors three precautionary rate cuts.
This combination has been cat-nip to value investors. Banks, in particular, have enjoyed a shift in bond yields that has made it easier for them to make a profit by borrowing cheaply and lending at higher rates. Industrials have been buoyed by hopes for another extension of the economic cycle.
If this is more than a flash in the pan, there are a few important implications for investors. The first is that an improving outlook for value shares is good news for the market as a whole. History shows that the best periods for investors are those when value is outperforming growth.
The second consequence is that if this change is for real then the pendulum is likely to swing for several years - growth has ruled the roost for a decade, while value was the predominant style for nearly as long after the bursting of the dot.com bubble in 2000. Investors tend not to hop quickly from one style to the other.
The third implication is that active managers, who have struggled for many years to beat the market, could have their moment in the sun again. An extended period of lower returns in which valuation plays a bigger role is an environment in which stock-pickers can earn their fees and start to fight back against the passive funds which have swept all before them in recent years.
Even if the pendulum is starting to swing back towards value there is no need to panic. In an uncertain world, reliable profits will continue to be attractive to investors. Disruptive technology and a trend towards winner-takes-all monopolies argues for some growth shares continuing to command high valuations. But a balance between growth and value looks increasingly sensible.
Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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