Americas CIO View

Manufacturing rebound? Signals are mixed even before the virus

The case for rotating to value from growth appears weak to us

Russell Large Cap Growth substantially outperformed Russell Large cap Value each of the past three years, including and to the surprise of many in the fourth quarter of 2019. In the autumn, many investors argued that a rotation in style leadership was finally upon us. Some argued for a shift in performance leadership from growth to value in 2020 on, supposedly: 1) an excessive valuation premium at growth vs. value, 2) an in progress or imminent acceleration of economic growth, manufacturing activity, earnings growth, 3) various mean-reversion arguments given wide return differentials between the two styles, the record stretch in duration of growth's outperformance, and some investor positioning or sentiment indicators perhaps too favoring of growth. However, we argued against rotating from growth to value late last year, or to at least maintain a balanced style strategy, and we still stick with this view. This note reviews why we think the growth- to value-rotation thesis is weak and why growth stocks deserve higher valuation premiums than history vs. the broad equity market, vs. value stocks and vs. their steady-state valuations when interest rates are far below history.

Growth stocks are long duration assets: low rates justify bigger premiums

When looking at a spectrum of securities arranged in terms of growth prospects – from high growth on one end to cyclical value on the other – our analysis based upon intrinsic valuation or discounted-cash-flow (DCF) models shows that companies with the best growth prospects are the greatest beneficiaries from lower interest rates. As interest rates decline, future growth is worth more to investors, while risk-free rates continue to be a larger portion of the cost of capital for defensive stocks. To borrow bond terminology, growth stocks have higher durations and convexities than their value counterparts. This makes high growth stocks the most sensitive to declines in interest rates (and value stocks the least), and thus, growth stands to benefit the most from a reduction in the real S&P 500 cost of equity. Low rates will likely continue into the future, and this is why we believe paying bigger premiums for growth makes sense in today's "lower for longer" interest-rate environment.

Observed premiums to steady-state P/Es are below history at growth

We believe, secularly lower interest rates justify higher steady-state price-to-earnings ratios (P/Es) for the S&P 500 than history and even more so for growth stocks. While we use simple and more complex DCF models to estimate fair P/Es under various interest-rate and explicit growth scenarios, we also evaluate the observed S&P 500 P/E and that of sectors by comparing them to estimated fair steady-state P/Es. This reveals any premium or discount to steady-state value today, which we then compare to what's normal for the S&P 500 and its sectors back in time. Despite multi-year outperformance of growth vs. value, we see that the growth sectors and mature growth stocks are just beginning to trade with a positive premium to steady-state value for their growth potential. While now positive, this growth premium remains below history, despite today's low interest rates justifying a higher premium than history, if all else is the same, including if their long-term economic profit growth potential is similar to history.

Acceleration remains absent: value outperforms on strong acceleration

Acceleration arguments for tactically favoring value over growth, generally rest on the notion that current profits at value are far below normal earnings potential and that a powerful recovery is imminent. This often occurs when exiting recessions. We do not expect a profit surge at key value sectors such as Energy, Materials, most Industrials, Auto, Retailers or most Financials in 2020. Not in the United States or abroad. And because P/Es are not depressed and rather elevated vs. norms at value (big banks the exception), we are skeptical that moderate acceleration is enough for value to outperform. Earnings-per-share (EPS) growth at growth and value are likely similar in 2020 and 2021, but the growth at growth is higher quality and more sustainable.

Trends and themes likely to persist even longer than usual

As we have long argued, we expect this expansion's longevity to shatter prior records. As such, we think economic trends, themes and areas of leadership in financial markets are likely to last longer than previously seen. We also think that when value has outperformed over long stretches of time or strategically that it was compensation earned for bearing uncertainty in controversial industries or companies. When growth outperforms over the long-term we think it is compensation for being patient. We think the combination of patience in a long expansion with the economy increasingly shifting toward services and knowledge based businesses favors growth.

Appendix: Performance over the past 5 years (12-month periods)

 

12/14 - 12/15

12/15 - 12/16

12/16 - 12/17

12/17 - 12/18

12/18 - 12/19

Russell 1000 Value Index

-6.2%

14.3%

10.9%

-10.6%

23.2%

Russell 1000 Growth Index

4.0%

5.3%

28.4%

-2.8%

34.7%

Past performance is not indicative of future returns.
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 1/16/20

 

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