While it is true the value indices have bested their growth counterparts recently, viewing the divergence through the prism of the factors does not tell us what is really going on in the market. The divergence has much more to do with the sector composition of the respective style indices than the actual growth and value factors. Understanding the sector dynamics will give us more insight into how sustainable the rally might be.
Though style indices are rebalanced regularly to ensure the individual stocks in them have the right characteristics, their sector makeup varies little. Over the last 20 years, for example, the share of financials stocks in the value index has been stable at around 28% (see Exhibit 2). Thought of another way, around 80% of the market capitalisation of the financial sector market cap is consistently in the value index; growth accounts for just 20%.
Chart shows sector weights of MSCI USA Value index.
Value stocks did not outperform growth stocks in all sectors
If the actual value and growth factors were behind the difference in the index performance, we would expect to see value stocks outperforming growth stocks in each sector. However, that has been only partly true during the recent rally.
Of the 11 sectors in the index,
- four have seen value stocks underperform growth stocks
- two have only marginally outperformed (see Exhibit 3)
- The remaining five have seen more meaningful outperformance of value stocks, but again things are not necessarily as they appear at first sight.
The sector with the greatest outperformance, financials, is almost entirely made up of value stocks, so it is not that value has outperformed, but simply that financials have done much better thanks to improved market sentiment and rising interest rates.
The next best performing sector, real estate, is in fact more balanced, with 37% of the index market capitalisation classified as growth and 63% as value, but the sub-industries tell a different story.
Of the eight real estate investment trust (REIT) sub-industries, five are value and three are growth. However, the performance of the sector overall has been driven mostly by retail REITs. These have benefited from the relaxation in lockdown restrictions, and they are all value.
The relative returns for consumer discretionary and communications services are largely explained by the underperformance of Amazon (consumer discretionary) and the remaining FANG stocks (included in comms services).
Along with tech stocks more broadly, they had outperformed significantly through the pandemic and valuations have become stretched (Amazon’s is trading at a forward price/earnings ratio of 96x). In our view, it is not surprising there has been profit-taking.
What about Europe?
The European indices do not suffer from the distortions that the ‘broad tech’ sector creates in the US, where the tech sector returns and valuations can overwhelm the rest of the market. Moreover, the outperformance of value has been even greater in Europe than in the US (8.2% against 5.0%) despite the smaller share of tech. A sector analysis nonetheless still offers a better view of the market dynamics.
Similar to the US, several sectors have not shown any relative outperformance of value versus growth stocks. The main drivers of the broader index outperformance have been the materials and healthcare sectors (see Exhibit 4).
The gain for materials stocks has largely come from the metals & mining industry, which has advanced by more than 25% since mid-May and almost entirely falls into the value category.
The chart shows the MSCI Europe index.
Healthcare stands out
Healthcare appears to be the one exception to the sector rule. Its outperformance has come from the pharmaceuticals industry, which is split between the growth (63%) and value (37%) indices. Despite the heavier weight in growth, value has outperformed by 10% since mid-May. Even here, though, the relative outperformance is not clearly driven by the value and growth factors.
The average return of the stocks in the growth index is 2% against 5% for those in value, a gap that is much smaller than the index differential. The outlier is the performance of Bayer, which has advanced by more than 20%. This is partly due to the resolution of tens of thousands of lawsuits in the US over insecticide Roundup. Bayer’s gains account for more than two-thirds of the value index return.
Can value continue to outperform growth?
Several of the performance drivers that led to value indices beating growth indices can persist for a while.
While valuations are actually somewhat above average for value stocks (the z-score for the price-to-book ratio is 0.4%), the ratio for growth stocks, and in particular broad technology, is at levels not seen since the tech bubble.
Multiples for value stocks have moved little since the launch of quantitative easing (QE) in response to the COVID-19 crisis, but growth stock valuations should eventually normalise (see Figure 5).
The chart shows the MSCI World index; value in legend is z-score.
Interest rates could rise further – 10-year US Treasury bond yields rose by 35bp from recent lows, although they have dropped back since – if US macroeconomic data surprises again, as it did last week with the better-than-expected non-farm payrolls numbers.
However, an improved growth outlook makes it more likely that fiscal stimulus (and hence Treasury bond issuance) lessen, and the US Federal Reserve is likely to continue to purchase large quantities of debt.
In our view, a temporary sector rotation that benefits value indices would not be surprising after the dramatic gains since the March lows. However, the broad post-GFC macroeconomic environment that has coincided with value’s persistent underperformance remains and with the secular winners from the pandemic likely to be much more represented in the growth indices than the value ones, we believe a major reversal is not in sight.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
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