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Has growth stock rally left value undervalued?

Dan Lefkovitz  |  19 Jan 2018Text size  Decrease  Increase  |  
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While most academic literature suggests value stocks always beat growth stocks over the long run, recent market behaviour has left many investors wondering when value’s resurgence will come.

The conclusion of academia is based on the assumption that investors are compensated for the risk of owning troubled companies with low-priced shares.

While the “dumb money” chases trendy growth stocks whose price-tags overestimate their prospects, “smart beta” ETFs prefer the value factor--companies that under-promise and over-deliver.

But recent market behaviour has left many investors wondering when value’s resurgence will come. Of course, predicting the timing of market inflection points is a fool’s game. The unexpected, powerful, and ultimately short-lived rally in value stocks after the US election demonstrates this point.

Valuation, however, can be used to predict long-term future returns for the growth and value styles.

Won’t value stocks always look cheaper, by definition? Not through the lens of a forward-looking gauge of share price relative to the intrinsic value of the business. Here, we rely on the work of Morningstar’s equity analysts. Applying their valuation estimates to value and growth indexes, value wins. 

Today’s US market valuations imply higher future expected returns for value stocks. That said, companies in this area don't look cheap on an absolute basis. The market’s advance from its 2009 nadir has left most stocks overpriced.

Current growth era not quite as "growthy"

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To appreciate the gap between value and growth, consider the 2017 Morningstar US Market Barometer. While the overall market climbed more than 20 per cent in 2017, that figure masked a wide dispersion between the right- and left-hand sides of the Style Box. In fact, the Morningstar US Growth Index’s 29.5 per cent gain more than doubled that of the Morningstar US Value Index.

 

2017 Morningstar US Market Barometer


chart


Source: Morningstar

 

Such growth dominance recalls the US market of roughly 20 years ago. But the performance differential during the technology, media, and telecom (TMT) bubble was larger. In 1998, the Morningstar US Growth Index returned 39.8 per cent versus the Value Index’s 14.1 per cent gain. In 1999, the Morningstar US Growth Index advanced 44.5 per cent, while the US Value Index declined 1.3 per cent.
Then the bubble burst and the tables turned. In 2000, the Morningstar US Value Index gained 10 per cent, while the Growth Index lost 28.5 per cent. The Value Index suffered far less than the Growth Index in the bear market of the subsequent two years and outpaced growth during the rally of 2003-2007.

 

Morningstar US Growth Index vs Morningstar US Value Index


chart


Source: Morningstar Direct

 

Then came the financial crisis, which hit value hard. The Morningstar US Value Index fell 58.8 per cent from 1 August, 2007 to 28 February, 2009, the timeframe utilised by Morningstar’s manager research team to capture the bear market. To be fair, the Growth Index also suffered mightily, declining 45.2 per cent over that period.

But growth has led Value off the 2009 bottom. Sectoral dynamics are part of the story. Financials, traditionally a value sector, haven’t fully recovered from the crisis; the rise of Amazon has crushed retail and real estate; and certain technology companies have booked record profits.

Macroeconomic drivers may also contribute. During periods of sluggish economic growth, the market prefers secular growth stories, for example, technology and healthcare.
Value did well in 2016 as the US election fuelled growth expectations, which lifted economically sensitive value sectors like industrials, energy, materials, and financials.

Whatever the case, growth has beaten Value in seven of the past 10 calendar years.

The fact that the highest-flying growth stocks are referred to by an acronym-- Facebook, Apple, Amazon, Netflix, and Google (FAANG)--is a cause for concern. Previous market epochs characterised by growth stock nicknames did not end well--see TMT of the 1990s and the Nifty Fifty of the 1960s.

Looking forward

If nothing else, the previous section demonstrates the cyclicality of style leadership. So, what do current valuations in the US market tell us about growth and value’s future prospects?

Morningstar equity analysts assign fair value estimates to companies using a discounted cash flow model. Economic moat, or sustainable competitive advantage, is a critical input.
A company with a moat around its business might look expensive according to multiples like price-to-earnings and price-to-book, but still be undervalued due to its ability to sustain profits. Ultimately, we believe that share prices converge with fair value.

Rolling Morningstar analyst estimates up to the index level, it appears that both growth and value are overvalued. The dispersion is significant, but not as dramatic as in the late 1990s, when TMT stock prices were completed disconnected from intrinsic value.

The Morningstar US Growth Index currently trades at a 14 per cent premium to analyst fair value, while the Value Index is seen as 7 per cent overvalued. The Core Index, which is pretty close to the overall market, is 9 per cent overvalued.

What’s an investor to do?

Of course, one could exit stocks altogether, though timing the market is notoriously difficult. Staying diversified across styles, market cap ranges, geographies, and stocks, bonds, and other asset classes is also sensible. Within equities, there’s also the option of being selective.

Choosing companies with a Morningstar moat rating is a useful place to start, and filtering further by opting for wide moat companies--tools that are available to Morningstar subscribers--provides another level of selectivity.

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Dan Lefkovitz is a content strategist for Morningstar’s Indexes group. . This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is strategist for Morningstar’s Indexes group.

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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