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On Value, Growth, and Ignoring the Fundamentals (GMO)

GMO White Paper – Whiplash: On Value, Growth, and Ignoring the Fundamentals, June 2017

  • After a decade of lagging relative returns, value equities delivered impressive performance in 2016, outperforming growth stocks by 10% in the US
    • Value started to break away in 2Q due in part to an improving economic outlook and a view that central banks would pivot toward a more neutral monetary policy
  • Spread between value and growth widened markedly in 4Q as 10-year Treasury yields rose and the budding reflation theme strengthened on the back of the election of Trump
    • In 2016, Russell 3000 Value Index rose 18.4% while Russell 3000 Growth Index gained only 8%
  • With an almost artistic symmetry, markets have all but completely erased last year’s gains for value over growth thus far in 2017
    • US yield curve has flattened and investors have shifted allegiance from cyclical opportunities to growth names
    • Outside of US, value and growth were more in sync until mid-March, at which point relative returns moved significantly in favor of growth

sector returns index concentration

  • Considering the top performing sectors of 2017 through May helps shed some light about important drivers
    • IT, Health Care, and Consumer Discretionary have been the hot sectors; given that these sectors are 70% of Russell 3000 Growth and only 24% of Russell 3000 Value, it is no wonder that value has had a difficult time pacing growth this year
    • Small number of very large stocks within IT have accounted for a significant portion of that sector’s strong returns: Apple, Alphabet, Amazon, Microsoft, and Facebook, Nvidia, Netflix were on average up 28% through May

The market is running ahead of fundamentals

  • In the US and emerging markets, some of growth’s strong absolute and relative performance is due to increased earnings forecasts on the part of analysts, though multiple expansion clearly has been the driver in those regions
  • US value stocks have seen little action in the way of either changing earnings estimates or changes in multiples
  • Overall, the lion’s share of performance gap between value and growth across the globe can be accounted for by an expansion in multiples that has outstripped even the habitually bullish analysts’ expectations for future earnings
    • This should be no small consolation to valuation-oriented investors: multiples running ahead of fundamentals is a classic sign of over-extrapolation by investors
  • On a forward-looking basis, GMO’s 7-year top-down asset class forecasts for value were only modestly more attractive than growth at the beginning of 2017 within the US
    • By contrast, in emerging markets, already had strong preference for value over growth coming into this year
    • Main component of our forecasts is mean reversion in multiples – continued multiple expansion during the month of May will only strengthen our preference for value over growth

The stars are starting to align for value

  • While underperformance is never pleasant, we believe there are “good” and “bad” ways for a value investor to lose over a short time horizon
    • First half of 2017 likely fit into the “good” category
  • Valuations for growth stocks are now pricing in earnings levels that are in excess of analysts’ expectations and the market is applying ever-expanding multiples to growth stocks while global profit margins continue to hover around record highs
    • This is all classic preamble to value outperforming as an expensive market retreats to lower valuations
  • Value stocks are currently negatively correlated with 10-year US government bonds and so value is also very well-positioned to benefit from a rising rate environment
  • With mean reversion, investor behavior, and interest rates all lining up on the same side, things are indeed starting to look up for value
Image Source: GMO
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