When investors talk about the equity markets, one subject often comes up: the extremely contrasting evolution of “value” and “growth” management styles.

Par Christian Schmitt, CFA, Senior Portfolio Manager

Growth stocks have been clearly ahead of value stocks for years.

Thus, the former have outperformed the latter 11 times out of 12 in recent years. Since the 2008/2009 global financial crisis, value stocks have only managed to outperform growth stocks once, in 2016. In recent years, more rumors of a value rebirth the stronger the growth stocks got ahead. This “rebirth” usually lasted only a few weeks, if not a few months. Reason enough to take a closer look at this subject.

The very definition of the styles “value” and “growth” already gives rise to differences of interpretation. The most popular approach relies on relatively simple valuation multiples such as the price / earnings ratio (P / E) or the price / book ratio (P / B). These determine whether a stock is cheap and assigned a value index or whether it is a high-growth stock that finds its place in growth indices. Almost all of the quantitative data on the subject is based on these assumptions and indices, including the statistics provided in the introduction.

But we can refine the analysis a little more. Value-style purists do not question the relatively simple methodology of index providers, but rather the concept of safety margin. The basic idea of ​​the value management style is that one can calculate an intrinsic (economic) value of a stock which, ideally, takes into account future expectations and the current market environment. If the market price of the share is much lower than its intrinsic value, the share can theoretically be bought at a discount and, with luck, subsequently sold for profit at a higher price. The graphic representation of this idea, which is found in the overwhelming majority of investor presentations, broadly resembles the graph 1 below.

Graph 1: Here is what the marketing presentations say
Graph 1: Here is what the marketing presentations say

Yes the graph 1 highlights the strengths of the value philosophy, it also contains an implicit assumption that can be questioned in practice and that most investors are usually not even aware of. The “value” strategy clearly emphasizes valuation, in other words, the difference between the current price and the expected fair value (or intrinsic value) of the share, as shown in the graph 2.

Graph 2: a question of point of view (short term)
Graph 2: a question of point of view (short term)

The future rise in intrinsic value, as suggested on the right side of the graph, is not straightforward. Structural growth has become a scarce commodity for businesses. But without noticeable growth, one wonders why a company’s value should increase in the long run. The error lies in a fundamental valuation assumption. Many valuation models are based on different growth scenarios for the planning horizon, which generally covers a period of five years. In addition, they assume that the business has an unlimited lifespan and its growth rate is constant. But if this expected growth does not materialize, the graph 3 then gives a much more realistic view of the subsequent development of intrinsic value than the idealistic representation of Graphs 1 and 2. More realistic, but much less suitable for a catchy commercial.

Graph 3: and this is how we fall into the “value” trap
Graph 3: and this is how we fall into the “value” trap

Nothing is cheap without a reason

Few “value” investors will tell you the opposite. However, one might rightly ask why a discount that exists today in relation to the intrinsic value of a share should subsequently dissipate, or even turn into a premium over fair value. Almost all areas of economic life are currently undergoing profound transformations that produce winners and losers. Investors who do not react to these developments with the required objectivity and flexibility run the risk of becoming trapped, both physically and mentally.

What the automotive sector has been experiencing for years is a perfect example. Value investors cite the sometimes extremely low valuations of traditional automakers who, with single-digit P / Es, have languished in the depths of the valuation rankings for years. The valuation argument is gaining all the more weight as market prices continue to rise in the context of the low interest rate environment. But what does the other side think?

Growth-oriented investors are highlighting the disruptive business models of current stars who, like the American electric car pioneer Tesla, are in direct competition with undervalued companies. But for the latter, the current valuation tends to take precedence over turnover and expected profits. The problem is that basically both camps are right and wrong at the same time. On the one hand, value stocks see their growth cut off by disruptive competitors, knowing that market prices may never come close to intrinsic value. On the other hand, the prices of growth stocks are much higher than their intrinsic value, which could lead to significant corrections if the growth expected by the market were not to be achieved. Consequently, neither can be characterized as good or bad investments.

Graph 4: a question of point of view (long term)
Graph 4: a question of point of view (long term)

How to resolve the “value” / “growth” dilemma?

By keeping in mind the strengths and disadvantages of each management style, investors can already avoid the grossest mistakes. Growth and valuation are both equally important. But the further we look and the more the investment idea is focused on the long term, the more the drivers of structural growth become dominant. The influence of short-term fluctuations becomes less important over time, as shown in the graph 4.

As long as the extremes of the valuation ranges carry increased risk, the middle lane will remain the most appropriate for cautious investors. “Middle” does not rhyme with “mediocrity”, quite the contrary: the middle track covers high-quality companies relying on structural growth engines and solid balance sheets while being valued at their fair value. It is precisely by betting on this type of company that Ethna-DYNAMISCH, the most offensive of the three Ethna Funds, has managed to avoid many “value” traps of recent years. As with other Ethna Funds, it is generally recommended to follow an ultra-flexible investment strategy in order to generate regular attractive returns whatever the market phase without being too dependent on fluctuating market regimes such as “value” cycles. or “growth”.

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