For real-time updates, do join our:
- Telegram Group: The InvestQuest
- Whatsapp Broadcast: Just send “Hello IQ” to +65 8840 2520
Difficulty: Moderate
1) Recap: Key Differences between Growth and Value Stocks
2) Value Stocks are at its cheapest relative value to Growth Stocks since the Dotcom Bubble
3) Key Catalysts for Value Stocks
Appendix 1: Polling data shows Biden leading Trump by a wide margin of 9.8 percentage points
The InvestQuest View
We see a bullish case for “Value Stocks”. In addition to trading at its cheapest relative valuation to “Growth Stocks” since the Dotcom Bubble, we believe that we are due for a style rotation catalyzed by, 1) the increasing probability of a Democratic Sweep of the US Presidency and Congress and, 2) a successful Covid-19 vaccine being announced.
Year-to-date, Energy has been the worst performing sector. In a subsequent article, we will review if this value-oriented sector warrants an investment.
1) Recap: Key Differences between Growth and Value Stocks
To explain this, consider two stocks Altria (a Tobacco company) and Netflix.
Most of us would agree that the Tobacco industry is in a mature phase. There is not much R&D required, growth is sluggish, and most importantly valuation multiples are undemanding. As a result, Altria has many characteristics of a “Value Stock”.
- Low Growth, with flattish sales for the past five years
- Low P/E Multiple of 9.3x (versus S&P 500’s 27x P/E)
- High Dividend Yield of over 8% (vs S&P 500’s yield of 1.7%).
On the other hand, Netflix is the opposite and has many characteristics of a “Growth Stock”.
- High Growth, with sales tripling in the past five years
- High P/E Multiple of 81x
- Low Dividend Yield. Netflix doesn’t pay out any dividends at the moment.
While some investors are better known to have a preference to one style, for example Warren Buffett and Value Investing, being able to effectively navigate between both styles can be rewarding. Note that Buffett had invested into Snowflake (a cloud-based data warehousing platform) and Amazon in recent times, not what most would consider as “Value Stocks”.
2) Value Stocks are at its cheapest relative value to Growth Stocks since the Dotcom Bubble
The chart below plots the relative valuation of “Value Stocks” vs “Growth Stocks”, going back as far as 1997. A positive z-score would imply that “Growth” is relatively cheap to “Value”, while a negative z-score would imply that “Value” is relatively cheap to “Growth”.
At the moment, “Value” is trading very cheap compared to “Growth” in RELATIVE terms. A z-score of -1.28 implies that from 1997 to date, there has only been approximately 10% of the time when “Value” was trading at a cheaper relative valuation to “Growth” than it is today, which is the period of the Dotcom Bubble.
In ABSOLUTE terms, the US stock market is not cheap, trading above its 20-year historical average P/E. “Value Stocks” are no exception, with large cap value stocks trading at 126.3% of its 20-year average P/E multiples (see image below). However, this is far less excessive compared to where “Growth Stocks” are trading, with large cap growth stocks trading at 163.6% of its 20-year average P/E multiples.
3) Key Catalysts for Value Stocks
In addition to Value Stocks being relatively cheap, we note a number of catalysts that may result in a rotation back to Value Stocks, providing near-term relative value trade opportunities.
Catalyst 1: Democrats win the Presidency and Congress
We see the likelihood of this happening to be approximately 61% (83% multiplied by 73% = 61%). We arrived at this figure by taking the forecasted probabilities made by “Superforecasters” from The Good Judgment Project.
- Likelihood of a Democratic Presidential victory at 83%.
- Likelihood of Democrats taking control of both the House of Representatives and Senate at 73%
Value Stocks should benefit from the implications of such a scenario due to:
- Potentially larger than expected fiscal package
- Reflationary backdrop from increased infrastructural spending directly favours Materials and Industrial sectors (see here for details of the proposed $1.5tr bill).
- Combination of loose monetary and fiscal policy could result in a steeper US yield curve, benefitting the Banking sector.
- Weaker USD
- A democratic sweep is likely the most USD bearish scenario, due to calmer geopolitics and larger fiscal deficits.
- A weaker USD tends to favor higher commodity prices, benefiting the Energy and Materials Sector.
- Increased regulatory risk around Big Tech
- Biden has proposed setting a minimum 15% tax on companies’ profits, in addition to raising taxes on foreign earnings of US companies. These reforms have a direct impact to the future earnings of tech companies, some of whom have kept their taxes low by stockpiling overseas earnings.
Note that the sectors beneficiaries mentioned (Materials, Industrials, Banks, Energy) are all known to have a large proportion of “Value Stocks”, while Tech has a “Growth” bias.
Catalyst 2: Successful Vaccine Trials
According to Goldman Sachs, Value Stocks would rally the most from a Covid-19 vaccine. In their study, “Value” has exhibited positive correlation with vaccine expectations, while “Defensives”, “Cyclicals” and “Growth” exhibited either negligible or a negative correlation with vaccine expectations.
The sectors that are classified as “Value-oriented” by Goldman have been highlighted in red below.
Upon a successful vaccine announcement, we imagine that investors will start rotating out of their “Lockdown” portfolios (the likes of Netflix and Zoom), and into the sectors that have been beaten down the most from lockdown measures, where we think that Banks and Energy will see revived investor interest. These two sectors currently hold a large proportion of “Value” as compared to “Growth” Stocks within the sector.
The InvestQuest View
We see a bullish case for “Value Stocks”. In addition to trading at its cheapest relative valuation to “Growth Stocks” since the Dotcom Bubble, we believe that we are due for a style rotation catalyzed by, 1) the increasing probability of a Democratic Sweep of the US Presidency and Congress and, 2) a successful Covid-19 vaccine being announced.
Year-to-date, Energy has been the worst performing sector. In a subsequent article, we will review if this value-oriented sector warrants an investment.
Appendix 1: Polling data shows Biden leading Trump by a wide margin of 9.8 percentage points
Be the first to comment