Follow the money

Investors are particularly vulnerable to what I think of as the Big-Endian question. In Gulliver’s Travels, Jonathan Swift satirised religious schisms by describing a long-running feud between those Lilliputians who preferred to crack their eggs open at the big end and those preferring the opposite, little end. He might as well have been referring to the stand-offs between investors over different approaches to managing money - the most hotly-debated of which today is that between the so-called growth and value investment styles.

Which of these creeds you have followed in recent years has made a significant difference to how you are feeling about your investments. And if this is all new to you, bear with this apparently arcane distinction because some investors believe we are on the verge of a watershed shift in the relative performance of these styles. Knowing your growth from your value could pay off in the months ahead.

Value investors are feeling sore at the moment. Their sceptical, contrarian approach to the markets is on the wrong end of a 13-year period of massive underperformance against their more optimistic, growth-focused peers. If you had invested £100 in value stocks in the summer of 2007, you would have just £128 today. If you had invested the same amount in growth stocks, you would now have £286. A staggering difference in such a short space of time.

Value investors appreciate certainty. They don’t want to overpay for what a company can actually deliver today, in terms of cash flow, business assets or dividends. In their nervous philosophy, it makes sense to only buy shares that are so cheap that, if things go wrong, as they probably will, there’s a reasonable chance of getting your money back.

Growth investors have a different view of the world. They see an abundance of opportunity in a world that is richer than it has ever been. They are prepared to gamble on uncertainty, hoping that they are buying the companies of tomorrow. Paying up for these future winners is not a problem because the growth to come will more than justify today’s apparently high price.

The outperformance of growth shares since 2007 is, counter-intuitively, a reflection of the scarcity of opportunities for expansion in the sluggish post-financial-crisis recovery. Growth shares have done relatively well because their promise of future growth looks attractive in this challenging environment. It has been helped by low interest rates, which reduce the opportunity cost of having to wait for tomorrow’s growth.

Investors are prepared to pay more for growth shares, and they are doing so. It will cost you more than £100 to share in every pound of Amazon’s profits. That’s five times as much as you need to pay for a share of the average American company’s earnings and maybe eight or ten times that of a typical value stock.

Value investors are particularly aggrieved at the moment because the gap between their returns and those of growth investors has widened further in the three months since the stock market noticed Covid-19. Their shares fell further in the correction and they have risen less in the recovery. £100 invested in late February is worth £96 in the average growth share and just £84 in the equivalent value stock.

Research by Credit Suisse suggests this is justified by the outlook. The bank expects the earnings of value stocks to fall by 42pc this year compared with just 13pc for growth shares. Investors may be paying a higher price for growth shares but that simply reflects their greater resilience. Value stocks are, on the basis of these figures, cheap for a reason.

No-one is disputing that growth stocks should be valued more-highly than value shares. The more important question is whether the divergence between the two has gone too far and for too long. The 13-year dominance of the growth style is more than three times longer than the longest comparable periods and about twice as long as value has ever outperformed growth. The size of the outperformance is much greater too.

Since the 1970s, the value and growth styles have handed the baton back and forth, with value outpacing growth by a big margin from 1975 to 1988 and again from the bursting of the bubble until the financial crisis. At some point, it is likely that the pendulum will swing back to value again - only the timing and the catalyst remain unclear.

If you want to see another indication of the extreme nature of the swing to growth in recent years, simply ‘follow the money’. In 2009, roughly equal amounts were invested in growth and value funds, 39pc and 41pc respectively, with the remaining 20pc in balanced funds that didn’t favour either approach. Today, the equivalent proportions are 17pc value, 57pc growth and 27pc balanced. The inevitable consequence of that weight of money is that the valuation of growth shares has not been higher relative to value shares in the past 50 years, not even during the technology boom in the late 1990s.

The evidence from the three big market crises of the past 30 years (1987, the tech bubble and the financial crisis) points to value shares doing better than growth as the economy emerges, having done worse during the crisis. This, together with the extreme divergence between the two styles, argues for value enjoying a return to favour sometime soon.

Unfortunately, long and painful waits for their moment in the sun are the lot of the long-suffering value investor. The moments when value is flavour of the month are brief, at times massively profitable, but rare. The rejection of the style over the past ten years confirms that most investors don’t have the stomach for it.

Tom Stevenson is an investment director at Fidelity International. The views are his own. He tweets at @tomstevenson63.