We have discussed how strong fundamentals coming out of the U.S have made it more than likely that the Federal Reserve will look to increase rates in the near term. A couple weeks ago we took a look at a few industries that might struggle in that environment, particularly if the dollar continues to rise. This week we want to take the time to walk through what a rising rate environment might mean for growth versus value stocks. Over the long-term and despite what the names may imply, value has outperformed growth stocks in what is known as the value premium. However, over the last 10 years, growth has outpaced value by about 2% annually and by nearly 10% in the last year alone. While this is not unprecedented, it does represent one of the longer cyclical outperformances of growth.
How does one connect rates and style performance? While there may be many reasons for the current cycle, an interesting way to frame the answer is by considering the discounting rate of cash flows. Growth stocks generally do not pay much currently and their value is derived from the assumption of higher cash flows in the future. Great examples of this in the current market are many of the tech stocks such as Google, Amazon, and Netflix. When trying to determine the appropriate price of a stock, deriving the present value of the cash flows is a common place to start. As long as rates remain low, the future cash flows are worth considerably more than if rates are much higher. In some ways, you can think of growth stocks as having some long duration risk to them.
What we have seen is as rates have come down, there has been sizable outperformance of growth relative to value over this time period. What has also occurred is that growth stocks have become relatively expensive in comparison to value especially when reviewing their Price-to-Book ratios
Does this mean the trend will reverse immediately? Not at all; cycles can continue longer. However, it does show signs of being unsustainable. Only a few of the largest tech companies are driving most of the market returns, typically a sign that a reversal in market leaders may be soon at a hand. With an improving economy and higher rates as a potential future background, value is set up to reverse the trend going forward and lead returns in the next cycle.
Pyne, Andrew. "Equities: Are Conditions Right for Value Versus Growth." http://blog.pimco.com/2015/11/24/equities-are-conditions-right-for-value-versus-growth/