In recent years, returns in equity markets have been mostly driven by investing for growth. This has given rise to increasingly larger valuations which are based over long term prospects of profitability.
The core objective of growth investing is to seek businesses which have a high level of growth. In the drive of doing so, companies without the level of profitability, scale and revenue that one would expect from business with the same level of valuation, have managed to attract strong investor interest seeking growth at all costs.
The definition,of value and growth equities, is not a rigid definition. It is acknowledged that over a span of time, growth equities transition into value equities. This is subject to different factors, such as innovation, capital expenditure, and overall, the pace of growth for the company. Historically both value and growth equities had periods of outperformance.
The recent trends indicate that we are currently in one of the longest periods of outperformance for growth equities in the last 45 years. For this reason, it may be the right time to revisit value equities. The lower price to earnings ratios of value companies compared to their growth peers is an indicator which should not be ignored.
It is important to note that given the current market valuations of US companies, investors should be more aware about the price they are paying for their equities. Last year’s, rally has driven multiples to a near historic high. All else being equal, this requires equities to outperform, in order to sustain such valuations, which may not be the case.
At the same time, value equities, tend to have a better ability to withstand adverse economic conditions. This can be seen in the overall lower level of volatility of these equities. The reason behind this tends to be that value companies are set in their own ways. By this I mean that, these companies, rather than being driven by the expectation of future growth, they are centred around a core offering, which they continuously optimise over the years. This is not to say that these kinds of companies do not tend to have growth prospects. It is however understood that the element of expected growth in their value, represents a much smaller portion.
To a certain extent, I would go on to argue that in this regard, value companies are more of a known quantity, compared to their growth counterparts. This in turn, makes them more viable candidates for your portfolio, when the expectations of growth wane, or the market is deemed to be approaching a juncture. In recent years, development of indexed funds and the hype around growth equities, has been rather unkind towards value equities, attracting capital away from them. This supports the thesis that, these companies are relatively undervalued compared to their actual valuations.
Another attractive feature of value stocks is that, they tend to have a higher dividend yield compared to growth equities. Given that these companies tend to have relatively lower capital expenditures, due to their relative maturity in terms of development, this tends to drive the dividend higher. This is not to say that these companies are risk free. To the opposite, different areas of value companies are facing off competition from disruptive technologies which may challenge their status quo.
For this reason, I conclude that despite the fact that value companies offer a haven in times of greater uncertainty, and an income yield which is comparable and, in some cases, surpasses yields in debt markets – investors should select their value company components within their portfolio, upon an in depth analysis of the company's financial strengths and its’ competitive environment.
Disclaimer: Daniel Gauci is a financial advisor at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, views and opinions provided in this article are solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.