Ideas Farm: Mind the valuation gap!

  • Does the huge gap between the valuation of growth and value shares mean there’s a growth bubble?
  • Ultra-low interest rates offer the justification for an ultra-wide gap.
  • Value stocks may be cheap relatively, but they are not cheap historically.
  • But value still looks interesting…
  • …as does growth.
  • Loads of idea generating data

As 2020 draws to a close, warnings of a bubble in growth stocks are cranking up again. The divergence between the markets’ most- and least-loved stocks has become a particular focus in this long-running debate.

Earlier this month, respected investment firm GMO highlighted the extreme gap between the valuations of growth and value stocks in its latest quarterly letter to shareholders.

This is a fairly clear cut observation from a firm well known for the quality and level-headedness of its research. But for investors, it is also easy to rationalise why this can be justified, and indeed, should be expected. 

In finance theory, interest rates have a major bearing on stock valuations. This is because they are a key component of a company’s cost of capital. The other important factor influencing cost of capital is the perceived riskiness of a company’s operations; something that’s far more slippery to define. 

The important thing to understand, though, is that falling interest rates mean a falling cost of capital. And a falling cost of capital is more beneficial to growth stocks than value stocks because it means growth becomes more profitable. In addition, lower rates mean investors need to ‘discount’ future earnings less, thereby making them worth more in the here-and-now.

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As an example, let’s take a ‘growth’ company that is expected to grow in perpetuity at 7.5 per cent a year while maintaining a return on invested capital of 15 per cent. We’ll compare it with a ‘value’ company producing no growth at all and with a return on capital of 7.5 per cent (companies with cheap shares tend to have limited growth prospects and often operate in competitive markets that limit the returns on the investments they make). A reduction in the cost of capital from 10 per cent to 8 per cent would in theory* justify a re-rating of the shares of our value play of 25 per cent, but a mammoth fivefold increase for our growth play.

True, this example lives firmly in the world of theory. Companies do not produce high rates of growth in perpetuity. What’s more, all kinds of uncertainties about the future affect judgements regarding cost of capital and potential return on capital. However, the example does illustrate the point that ultra-low interest rates in the developed world justify an ultra-wide gap between the valuations of value and growth stocks.

Indeed, as well as a wide gap for the market as a whole, GMO finds such valuation gaps within individual industries, countries and baskets of companies with similar balance sheet characteristics. This is something that would suggest to me a big macro-factor is at play.

The influence of low interest rates may also be reflected in the fact that while value stocks are extremely cheap compared with growth, they don’t look that cheap compared with history. The price to forecast rolling-12-month earnings ratio of the MSCI World Value Weighted index is close to the highest it has been in the last five years at 14.8 and well above the median average over that period of 13.5.

There are reasons to like value stock at the moment that have little to do with comparisons with growth. Should a recovery prompt a pick up in interest rates expectations, or even the emergence of above-target inflation, value has a lot less to lose. What’s more, the pandemic has exposed the major weakness of value plays: their earnings tend to be very sensitive to economic shocks. The flipside from the 2020 devastation is that value should have much to gain when life gets back to normal (or the new normal). And behavioural finance suggests the events of 2020 may have made investors overly pessimistic about value stocks as well as overly optimistic about growth (the ultimate foundations of any bubbles). 

But growth is not without its attractions, either. Innovation is occurring at a blistering pace and those companies that tap into key trends could offer investors excellent returns over the long term even when ratings look full. This week’s Idea Farm list of fund managers’ best tech ideas aims to give a pointer to where the best opportunities from innovation may lie.

*Based on an adapted Gordon Growth model

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