Bryan Cameron, Senior Vice President and Head of Research at Dodge & Cox, discusses whether now is the time to rotate out of global quality (growth) stocks into global value (cyclical) stocks.
How did we get here?
The set up for this rotation goes back about 3 or more years where we saw a strong outperformance of growth over value. The valuation measurement shows that growth stocks are expensive in both absolute and relative terms compared to value. So why did this happen? Firstly, there was a period of exceptionally low interest rates around the world, which impacted entire markets and within markets we were favouring growth or compounder areas. Second was the dominance of high technology and the so-called FAANG group with the S&P 500 3-year returns dominated by just five companies – Amazon, Facebook, Apple, Google and Microsoft. These stocks now comprise 21.7% of the index and last approached these levels in March 2000 (at 18% of the Index). Third was the exogenous shock of Covid, which was an exclamation point on the growth versus value dynamic within world markets.
Covid divided US stocks into Covid defensives vs cyclicals
Covid divided equity markets into winners and losers. In the first 9 months of 2020, the leading S&P sectors were information technology up 29%, consumer discretionary up 23% and communication services up 9% relative to the S&P 500 being up 6%. In contrast, the losers were energy down 48%, financials down 20% and industrials down 4% over the same period. What was critical after this happened was how you were positioned. Covid defensive stocks included companies that were either not impacted financially or were advantaged by the stay-at-home environment and stocks that were strong outperformers with valuations at significant premiums. Covid defensives were dominated by technology, healthcare and consumer sectors. The Covid cyclical area conversely had significant impacts to their businesses, their stocks were the laggards and valuations were quite depressed. Financials, energy and industrials dominated this group. At the end of 2020, the S&P 500 was 70% Covid defensive and 30% Covid cyclical, the Russell Value was almost 50/50 while the Dodge & Cox fund was 38% Covid defensive and 63% Covid cyclicals. We had a very strong conviction that the place to be was in the laggards and depressed valuations, which included financials, energy and industrials.
A reversal of fortune for value stocks in Q4 2020
What’s happened in retrospect is a reversal of fortunes, which began on 9 November 2020 when effective vaccines were announced by Pfizer and Moderna and we saw value starting to outperform growth. Financials, energy, industrials and materials were the leaders in Q4. Technology was treading water and was in the middle relative to indexes. The laggards were defensive areas, such as consumer staples, healthcare and utilities. The backdrop for this is that the valuation gaps between the growth and value area are still quite large. What has happened and what we expect to continue is that the bottom of the market, defined by valuations and levels of expectations, specifically finance, industrials and energy, has risen. The keys were the vaccines leading to a healthcare recovery leading to an anticipated full economic recovery. Along with this came the chance for higher interest rates, which we are starting to see. Many people did not expect this, given central bank policies around the world. In the US, the 10-year treasury has already risen from zero to 0.5% at the bottom to 1.6% today. This obviously helps certain sectors in the value camp, such as finance, but tends to hurt the high-growth area. There is also an opportunity with a full economic recovery for higher oil prices, which has happened and oil has risen from $20/barrel to $65/barrel. The other part of the argument, which is only starting to happen is that the top of the market could very well fall through and this started happening in the last month or so. Valuations are very high and we think higher interest rates are likely to knock some of the froth off valuation metrics for high growth stocks. We think there are specific challenges for many high tech stocks, which aren’t fully appreciated, specifically market saturation, competition, technological change and a change in the legal and regulatory environment that they face.
It’s not as simple as growth vs value
One caveat to this is that it’s not as simple as growth versus value or quality versus cyclical. As an example, we were overweight pharmaceutical stocks because of the level of innovation, the exposure to emerging markets, strong earnings, free cash flow and reasonable valuation metrics with many of the stocks selling in the mid-teens P/E ratio. So far in 2021, markets have continued to move strongly with value dominating growth. The magnitude of this outperformance in favour of value for Q1 is at least as big as or greater than Q4 2020. In the last four and a half months, there’s been a sudden and dramatic move in favour of value oriented stocks away from growth oriented stocks. Certainly there are no guarantees where we go from here, but anticipate that conditions are still quite good for this trend to continue. Hence our conclusion that we’re in the midst of a significant rotation within the markets from growth to value.