The growth vs value debate

With oil prices and inflation rising once again, markets are back to early 2021

The markets have sparked a raging debate among global investors over growth versus value. Having underperformed for more than a decade —and facing existential issues in some cases— value investors are sensing a turning of the tide. They see a sustained period of value outperformance ahead, similar to what happened in 2000 when the tech bubble burst. While these classifications are not that important among Indian investors and funds, they define the global investment landscape. Most funds are clearly bucketed in either the growth or value camp and cannot deviate from this mandate. The superiority of one style over the other has massive implications for sector rotation, fund flows and even the emerging market asset class.

It is a fact that the small- and mid-cap growth universe has been totally decimated in the last few months. This has gone unnoticed by many as the broad index has held up, with the 10 largest tech companies having a banner year in 2021, rising almost 40 per cent. Nearly, 35 per cent of the Nasdaq companies are down more than 50 per cent from their 52 week highs. The Russell 2000 growth index is down more than 20 per cent from its high in February 2021. The damage is across the board, with biotech, Fintech and even SaaS software companies in free-fall. The momentum part of the market, be it Spacs, meme stocks or unprofitable tech, has been even more badly hit. When stocks were trading at 25 times sales, even after correcting, valuations still look challenged. It does appear that the bubble in the high momentum, loss-making, valuation-insensitive concept stocks is coming to an end. We will need another surge in liquidity to get them back on their feet, and it seems highly unlikely that the Federal Reserve will oblige. The Fed seems more determined to withdraw liquidity, tighten financial conditions and eventually shrink its balance sheet. In a scenario of tightening financial conditions, I do not see how these stocks will regain their mojo. Inevitably in the bust, all these stocks will decline, but many have fundamentals which are incredibly robust. Some do deserve their hype and this bust will throw up serious stock-picking opportunities. Everything was not a bubble.

However, the bust in these momentum names will make it even more difficult for the growth universe to outperform. With these stocks poised to remain weak for some time, for growth as a category to perform well, all the burden will fall on the big-cap tech platform stocks (FAANGM). While they have bailed out the growth universe in 2021, with the top 10 tech stocks up over 40 per cent, this level of outperformance is unlikely to continue. In the absence of the platform and semiconductor Titans sustaining their outperformance, growth as a category will be challenged.

Illustration: Binay Sinha

We have been at this juncture before. At the beginning of 2021, the set-up was quite similar. US bond yields jumped as the hope of vaccines bringing a quick end to Covid-19 was the consensus and global growth was surging. The rumblings on inflation had begun and oil prices were threatening to break out. Value had begun to outperform growth and the much anticipated rotation was deemed to have begun. The market seemed to sense an imminent inflationary boom.

The whole move got short-circuited as the Delta variant spooked markets and lowered growth expectations, combined with China delivering a negative surprise. China caught the market unawares with its move against its technology giants and willingness to inflict pain on its over-leveraged real estate sector. With the passage of time, its zero Covid policy seemed unrealistic and a growth headwind. Most investors were forced to lower their expectations for Chinese economic performance and its contribution to global growth.

The combination of the above pushed investors back into the safety of mega-cap technology companies and the value rotation fizzled out, at least among the larger companies.

Today, we seem to be back to the early 2021 scenario. Oil prices and inflation are breaking out to the upside, with March likely to be the first rate hike by the Fed, and murmurs of balance sheet shrinkage/normalisation. No one is talking of transient inflationary pressures. All the rhetoric coming out of the Federal Reserve system is designed to convince the markets that it is serious about controlling inflation. The Fed is clearly behind the curve.

With rising inflationary talk, yields have naturally also started to move up. At approximately 1.75 per cent, 10-year bond yields are at the top end of their post-Covid trading range and threatening to break out. Real yields, while still negative, have begun to rise. Rising real yields are a much greater headwind for the markets than nominal yields.

With oil, inflation and bond yields all threatening to break out into new trading ranges, value has also once again started to outperform.

With few portfolios positioned for sustained higher yields, oil prices, or inflation, if these trends stick, the market adjustment will take time. Even the value/growth reversal has just begun. As mentioned, growth has outperformed for more than a decade, since the global financial crisis, taking advantage of non-existent inflation, slow global growth and continuously falling bond yields. We will need to see major portfolio adjustments if global investors move towards a more value tilt.

There always exists the possibility that we could have another global shock, which can stop the move towards a reflationary boom in its tracks. The obvious candidates are a crisis in the Ukraine, another Covid variant or further geopolitical tensions between the US and China. Another cause of a reversal could be a Federal Reserve mistake. If the Fed were to hike too aggressively and tip the economy into a serious slowdown or recession, then value will get slaughtered and risk averse investors in search for a safe haven will once again be drawn to the FAANGM platform stocks, which deliver growth and are less economically sensitive. The debate is no longer whether the Fed will tighten? It will. The risk is, in an attempt to regain credibility, will it move too much, too soon? In such a scenario, you have two polar opposite views. Some think if the Fed overplays its hand, then investors will flock back into the safe havens of structural, technology lead growth companies. Others feel value stocks/sectors will actually benefit from the Fed tightening as higher rates will corrode high multiples, and a strengthening economy and broadening growth, leading to faster Fed normalisation, benefits value.

In the absence of some new shock, at least for the immediate future, investors need to be prepared to see more outperformance from financials, energy and industrials. Global commodities are likely to continue their upwards trajectory as well. Are you positioned for this type of market move?

The writer is with Amansa Capital