3rd December 2020: November’s rally in global equity markets was almost without parallel. For European stocks it was the strongest month ever recorded, while for the US Dow Jones Index, it was the largest gain achieved since 1987. Similar records were broken in this part of the world with the ASX200 finishing up more than 10%, its best return for 32-years. Domestically the NZX50 closed 5.7% higher. In a year which has been defined by uncertainty, these positive outcomes are a clear representation that the world is recovering. Positive vaccine news and the removal of uncertainty surrounding the US election has created a platform for optimism. The past month though will also be remembered for something similarly dramatic - the massive rotation of investor support back into Value stocks.
Value based investing is typically defined as the purchase of shares which are trading at a discount to their intrinsic value. This sits in contrast to the traditional alternative, Growth, which involves investment into those businesses which exhibit signs of above-average growth, despite their stock prices at times looking expensive. Throughout history, Value has typically outperformed but this experience has been notably different since the Global Financial Crisis (2007-2008), as central banks printed money and slashed interest rates. This backdrop created a tailwind for Growth but in the past year the relative performance differential between the two styles has widened further. The primary reason for this was the onset of the Covid pandemic, as those stocks that were listed in the more value-oriented sectors such as Financials and Consumer Discretionary significantly underperformed due to the impacts of the pandemic. In fact, as at the end of October the size of the differential in performance between Growth and Value styles was at its widest margin in 40-years (beyond even the level that was evident during the technology boom and bust in the late ‘90’s). As history tells us though, mean reversion is possibly the most powerful tenet in finance and at times when performance gets extended to these levels, an adjustment back was almost always going to happen.
As investors were confronted by the challenges posed by the pandemic earlier this year, the environment for Growth became understandably productive. As global economic activity collapsed, those businesses that were able to sustain positive earnings momentum despite the GDP cycle were keenly sought after. Also, as central banks sought to offset the economic disruption from Covid through liquidity initiatives and the cutting of interest rates to zero (or negative in many situations), the valuation benefit for those companies that offered earnings in the distant future (i.e. Growth companies) were further supported. This led to a massive redirection of capital flows into Growth stocks from institutional investors and retail platforms such as Robinhood in the US, and our local version, Sharesies. The consequence of this, in late October, was twofold. Firstly, we saw a massive lift in benchmark concentration, with stocks such as Microsoft, Apple, Amazon, Alphabet (Google) and Facebook accounting for an increasing percentage of the major global indexes (for example, these five stocks recently accounted for almost 40% of the major Russell 1000® Growth index). Secondly, valuation premiums in this sector became extended. In recent months the price-to-earnings (P/E) premium for global Growth versus Value reached a record high of 220%. Another way to demonstrate this is to look at the largest index in the US, the S&P500. The forward P/E for the S&P500 is slightly more than 20-times. However this headline outcome hides much of the more interesting detail which sits below the surface; the average P/E of the top 5 technology stocks in the index is much higher at 47 times, and remarkably that outcome is still positively cheap compared to the even greater multiples being paid for small and medium sized tech companies.
History has shown us on many occasions that when investors ignore valuations, they are taking huge risks. Whether it be in times such as the Nifty Fifty era in the 1970’s or the Tech Bubble in the late 1990’s, growth at any price is not a sustainable investment strategy. The challenge for investors is determining how much they should pay for the promise of growth, acknowledging that it is very difficult to sustainably generate high rates of growth over the long term.
For a few months now, we at Devon have highlighted that the period of outperformance by Growth was looking extended well beyond fundamentals. Not only were we witnessing the longest period in history of dominance by Growth, but the key drivers of style performance were changing. We believe that a sustainable shift in the stocks and sectors that will lead the markets in 2021 has begun. Global economic growth is improving rapidly. Driven by the massive stimulus measures that have been implemented by central banks and governments, activity levels have lifted and will continue to improve into next year. Expectations are that world GDP will improve by more than 5% over the next 12-months, with contribution coming from a broad range of sectors. This dynamic, together with an explicit acknowledgement from institutions such as the US Federal Reserve that they will welcome above-trend growth and above-target inflation, has also substantially increased the likelihood that yield curves will steepen. This macro backdrop is likely to also sponsor a strong recovery in corporate earnings, especially for those businesses whose performances are tied to the economic cycle. This is ultimately very positive for Value-based investing. Although the conditions which influence markets are always changing, history tells us that when these style rotations occur, they tend to be long-lasting. The following chart demonstrates how this recent Growth leadership follows a long period of Value outperformance.
Although many commentators have identified November as the month when the rotation from Growth to Value began, we believe that it actually started a few months earlier. Many of the sectors which were initially identified as being most-at-risk due to the pandemic started to rally back in September. Industries such as Airlines, Retail, the Financials and the Resources all became the target of investor interest and their share prices began to move accordingly. In the past month though, the rotation picked up speed. The Australian Banks are a great example of this. As a sector, they have faced a range of challenges over the past few years. Headwinds were created by competition, regulation and finally by a perception that Covid-related economic distress would lead to a substantial lift in bad debts. These conditions resulted in stocks such as National Australia Bank and ANZ being down 15% and 17% respectively in the two years to the end of October 2020. The ASX200 Index over that same period was up 9%. In November these banks both rallied by more than 20%. They did this for all the reasons that we have highlighted above, being those consistent with the Value style. As the economy recovers, these stocks, and others in their sector, offer investors compelling valuation support and the potential for dividend yields which are multiple-times larger than the alternatives with corporate bonds and term deposits.
As the world embarks on a process of vaccine-inspired normalization with respect to social distancing and ultimately business conditions, we believe that the style shifts that were evident last month will continue well into next year. If history is a guide, this rotation could in fact take years to play out.