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It is a key theme of “Good Idea, Bad Investment?“: just because a stock looks like a bargain, that doesn’t mean it is worth buying. A variety of often unexpected developments can influence its price, including macroeconomic trends; competitive, regulatory and other threats; and changes in investor sentiment, which can undermine ostensibly positive company-level fundamentals.
Another factor that can also come into play is whether investors prefer investments categorized as “value” or “growth,” and where these two styles stand in comparison to their history and the broader market.
A quick Internet search reveals a variety of definitions about what these terms mean, but the basic idea is pretty straightforward. Value stocks are those which are considered inexpensive based on various metrics, and which tend to grow at a relatively slow and predictable pace. Growth stocks, in contrast, tend to be more richly valued–sometimes aggressively so–and have earnings and revenue trajectories that are steeper and more unpredictable than stodgier counterparts.
Waxing and waning
Interest in and the relative performance of equities that fall under either heading tends to wax and wane, influenced by the broader investing environment and risk preferences. Many investors might favor growth stocks during times when business conditions are less than robust, but become more risk averse–that is, value-oriented–if the economy falls into recession.
Investor attitudes about risk-taking and the appropriate balance between risk and reward can also play an important role in determining which factor finds favor. Until recently, an aggressive hunt for higher returns and a penchant for risk-taking, inspired and encouraged by the Federal Reserve and other central banks following the 2007-2009 global financial crisis, led investors to favor growth over value.
However, things have changed in the wake of the Fed’s initiation of a long-anticipated tightening cycle in December after seven years of aggressive monetary accommodation. Since then, questions about when the Fed might raise interest rates again, the state of the economy (discussed here), credit conditions and overall liquidity have spawned considerable uncertainty, leading many investors to become more conservative and dial back exposure to riskier securities, sectors and styles.
The pendulum swings the other way
One result has been a pick-up in the relative performance of beaten-down investments, as well as an exodus from those that had once seemed impervious to broader selling pressures, especially during the latter half of 2015. While it remains early days, this preference shift looks to be playing out in a way that at least some commentators had predicted. CNBC noted back in December, for instance, that a numerous investors were suddenly “very long the Alcoa’s and Exxon’s of the world” in anticipation of a turnaround.
The article also highlighted a paper by investment firm Gerstein Fisher noting that there have been long periods where one style has dominated over the other. In fact, history suggests there is a relatively predictable relationship between the two. Over the last 60 years, as the following chart shows, growth has outpaced value for several years at a time, after which things have swung the other way. Based on what has happened since the crisis, it appears that the moment has come for inexpensive and predictable to move to the forefront.
So far, the performance of value-oriented securities appears to be bearing this out. Among the biggest relative winners since 2016 began are two sectors that had been hit hard by the collapse in oil and other commodities: energy and materials. Last year, for example, the Energy Select Sector SPDR exchange-traded fund (XLE) fell 21.5%, lagging the 0.7% drop in the S&P 500 by more than 20 percentage points. Year-to-date, the ETF has lost just 3.5%–despite the fact that energy prices remain near multi-year lows–while the broader market is down 6.2%.
Falling back to earth
Meanwhile, a group of four stocks, the “FANG”s–Facebook, Amazon, Netflix and Alphabet (Google)–which defied gravity last year as an expanding list of stocks faltered, have suddenly come crashing back to earth. After two months, the members of that once red hot group are all lower–in the case of Amazon and Netflix by more than 20%–following 2015 gains ranging from 34.2% for Alphabet to 134.4% for Netflix, one of last year’s biggest S&P 500 index winners.
As noted in “The Right Environment for Active Investing,” developments also support the notion that conditions are reverting back to a time when traditional equity drivers, including valuation, will play a more important role than they have for some time. Rather than reacting to the risk-on/risk-off dynamics of recent years, investors are finding that company-specific fundamentals matter as much as monetary policy or macroeconomic themes.
More broadly, sinking ships–or companies–won’t have the backstop of the rising tide of lower rates and liquidity that lifts all boats, and will be more closely scrutinized to see if business models make sense and financial conditions are up to snuff. Taken together with a sudden and widespread appreciation of the meaning of risk, it is not hard to see that investments that offer value, so to speak, will be leading the charge in the period ahead.