Since the financial crisis, quality growth has outperformed value in Europe. High quality, defensive companies with predictable earnings streams have vastly outperformed cheaper cyclical companies with more variable earnings.
Given this performance, investors should be forgiven for favouring quality growth over value. In the IA Europe ex UK sector, only 7.7 per cent of total assets are invested in value-focused funds, whereas the figure for growth stands at 43.4 per cent, according to Morningstar. The balance favours core funds.
Today this investor positioning looks dangerous. The evidence is building that expensive defensive stocks are likely to underperform further.
Elevated valuations in many secure growth companies have removed their margin of safety, rendering these companies susceptible to multiple compression. On the other hand, value stocks with large price support are becoming safer.
After a period of outperformance in the second half of 2016, value in Europe has lagged growth in 2017, albeit only moderately. Is the resurgence over? A combination of factors makes me confident that the best is yet to come.
Falling interest rates are kryptonite for value strategies – and rates are no longer falling.
Value remains out of favour today because of the steep bear market vs growth since 2007, but over the long term, value has outperformed significantly. Since 1927, US value stocks have outperformed US growth stocks by a factor of five times.
Contrary to popular belief, value has also been extremely consistent, outperforming growth in seven out of 10 years over the past century. There have only been three bear markets in value over the period: the Great Depression in the 1930s; the Dotcom bubble in the 1990s and, most recently, the period following the Global Financial Crisis between 2007 and 2015.
The one factor that has been ever-present during these periods is sharply falling interest rates, which is damaging to value strategies. Why? When long-term bond yields fall, discount rates fall, and so the present value of future earnings increase. For companies with defensive and predictable earnings growth this is positive, they see high multiple expansion. But for those that have less predictable earnings growth, that is, value companies, the multiple expansion is smaller.
Crucially, rates bottomed out in Europe in the first quarter of 2016. Historically, value has not needed rates to rise for it to outperform, stability is enough. We saw what European value was capable of last year in a stable rate environment.
- Quality growth has outperformed value in Europe
- The ECB is about to embark on its tapering programme
- High valuations mean that many growth companies have high price risk
When the ECB pulled the European banking system back from the brink and committed to stop cutting rates, value outperformed growth by a wide margin.
Concerns about Donald Trump’s leadership and tensions in Korea have resulted in bond yields falling in 2017, and thus value’s recovery has rightly paused. However, the scope for yields to fall much further is small.
The ECB is about to embark on is tapering programme, the European economy continues to surprise on the upside and European political concerns are on the decline. The trajectory on rates is more likely upwards. These are favourable conditions for value.