Value-turned-growth stocks – understanding the value cycle

Growth stocks have consistently outperformed value stocks for the past 12 consecutive years. Put another way, investors holding mostly growth stocks over this period have had significantly better outcomes than those holding mostly value stocks. How has this affected value investors?

Growth stocks are companies that are growing their sales and earnings the fastest. Value stocks are those that are the cheapest when measured by traditional valuation metrics (price-to-book ratio, price-earnings or P/E ratio, and dividend yield). These definitions are used by MSCI to construct its World Growth and World Value indices. A closer look at the geographic and sector compositions of the indices reveals further distinctions – as well as interesting similarities.

The geographic compositions of the two indices are largely aligned. Where the indices differ is at the sector level, with several sectors currently falling clearly into either growth or value territory. Information technology and consumer discretionary are currently clearly growth sectors. Financials and high-yielding sectors such as real estate, energy and utilities, on the other hand, are currently value sectors.

There are often anomalies within sectors. For example, in the consumer discretionary sector (a growth sector), there is a wide divergence between the valuations of growth stocks and value stocks. In healthcare (roughly equally split between growth and value), there is a wide divergence between biotechnology companies and all others (hospitals, insurers, etc.).

Value asset managers following a bottom-up approach, i.e. who buy and sell equities based on their intrinsic value, rotate out of stocks when their price exceeds the manager’s assessment of its worth, and buy when they identify mispriced quality. Using this method, the distinction between growth and value often blurs.

In May 2016, our funds’ global holdings contained many stocks now classified as growth. However, a few years earlier we’d identified them as value stocks as they’d become cheap. By 2018, the stocks were reaching valuation levels we considered expensive. At the same time, pockets of value were starting to emerge elsewhere in the market. We therefore started selling the expensive stocks and buying cheap ones.

South African growth and value stocks have shown similar trends to their global counterparts. As the local economy isn’t growing, it’s difficult for domestic-facing (SA Inc.) companies to produce growth. Therefore, local stocks can be regarded as growth stocks if they’re taking market share.

While SA companies aren’t included in either the MSCI World Growth or MSCI World Value indices, similar market dynamics have been at play: the divergence between those that are exhibiting fast growth and those that aren't is extreme. The divergence between the share prices of Capitec and its competitors, and between Clicks and Shoprite, are good illustrations.

Since its inception, Capitec has produced unmatched growth relative to other SA Inc. companies, and has continued to take market share from both the big four banks (Nedbank, Standard Bank, FirstRand and Absa) and informal lenders. Investors have seized the opportunity to benefit from this growth, driving the Capitec share price to all-time highs in recent years, both in absolute terms and relative to peers. Comparing its valuation to Nedbank, reveals the extent of the valuation divergence. At the end of December 2019, Capitec’s share price traded at a 384% premium relative to Nedbank’s, compared to a long-term average of 192%.

While Clicks and Shoprite have historically traded at similar multiples, they’re now displaying a wide divergence in valuations. Both companies sell everyday goods − in many cases to the same consumers. Yet the recent experience of investors in the two companies has been vastly different, again due to growth. As Clicks continues to take market share away from independent pharmacies, its growth has exceeded that of the average SA Inc. company. But as with Capitec, investors have driven its valuation to all-time highs. In fact, the valuation premium of Clicks over Shoprite is 133%, versus a history of trading on average at similar multiples.

In conclusion, labels such as ‘growth’ and ‘value’, while convenient, are insufficient and imperfect guides for investors. What matters more than anything in producing long term out-performance is the price you pay for a stock, relative to its intrinsic worth.