Point/Counterpoint: Value Vs. Growth

By Peter Nurse and Yasin Ebrahim

Investing.com - Stocks have continued to climb, with the S&P 500 finishing a holiday-shortened week above 3,000.

But rather than previous weeks, diversity has been the name of game, with stalwarts like financials enjoying buyer confidence after techs being the darlings for a while.

Is now the time for investors to look at more than just the FAANG stocks, or will the Nasdaq high flyers continue to be the standard bearers?

Peter Nurse says that the worst looks over for financials, which are still well off their lows, while quality retailers will shine as the more vulnerable ones disappear.

But Yasin Ebrahim argues that the enthusiasm for value stocks is a flash in the pan and growth stocks are simply worth more in a low interest rate environment.

The Cyclical Case

U.S. stock indices have recovered back to the levels seen in early March, and it’s been cyclical stocks which have attracted a lot of the fast cash of late. There is still upside for investors to mine, especially where the flirtation with bankruptcy has been the heaviest.

“It's always difficult to trust the cycle at the trough. However, price action suggests it's not different this time. In fact, the cheapest stocks have never been cheaper and this argues for leaning even harder into the wind,” Morgan Stanley (NYSE:MS) analysts said in a research note, published on Wednesday.

In the early stages of the recovery, the strong policy support, both fiscal and monetary, reignited a search for yield, said Goldman Sachs (NYSE:GS) in a research note to clients published on Thursday. But the pick-up in risk appetite has been due to more optimism on growth, it added.

Shocks, such as pandemics, tend to accelerate changes already underway because some of the arguments and forces resisting change are temporarily weakened by short-term necessity.

With falling mall sales and increased online competition, some retailers were struggling before the coronavirus pandemic began. Covid-19 has accelerated their demise, rather than caused it.

But the likely disappearance of some of the weaker members of the herd creates space for quality retailers to shine.

Morgan Stanley points to PVH (NYSE:PVH), one of the largest global apparel companies, with iconic brands such as Calvin Klein and Tommy Hilfiger, as a retailer offering healthy upside to its 12-month target of $77.

It’s also important not to forget banks, a sector which can still move with the crests and troughs of economic growth.

Morgan Stanley noted that while early cycle sectors are doing better from the low points in March, the most unloved sectors could still have a long way to go should the recovery continue to make progress.

Obviously there are areas that have been absolutely crushed by the social distancing measures taken to combat the coronavirus outbreak - airlines, cruise liners and mall owners, spring to mind - but the banking sector has also been hurt.

This is mainly due to the very low level of interest rates rather than any balance sheet issues, like during the recent Financial Crisis. Low rates have killed bank profitability in Japan and Europe and there's little reason to suggest the impact will be different in the U.S.

But the Fed has taken every possible opportunity to dismiss the use of negative rates and the two-year Treasury yield hasn't seriously threatened a new low for three weeks now. If the worst really is over, then so too is the risk of negative rates, and bank stocks should respond accordingly, yet JPMorgan (NYSE:JPM) is still nearly 40% below its pre-pandemic levels.

While the mortgage market seized up at the start of the coronavirus outbreak as the number of people seeking new loans dwindled, historical data from the late 1990s show a financial crisis is often followed with a steep increase in housing prices and demand for loans.

Morgan Stanley turned overweight on JPMorgan in April, and points to Citizens Financial (NYSE:CFG) Group as its newest overweight recommendation in the financials sector. It has a price target of $32, offering some 20% upside to the current level.

The Tech Case

Value stocks had their moment in the spotlight this week, prompting some to suggest the great rotation from value to growth is in play.

But a quick look at recent history signals the move in value this week may ultimately prove equivalent to the makings of a flash mob: fashionable in the moment, performs for a brief time, followed by a quick dispersal.

Value stocks are down nearly 20% this year, while growth stocks, seen as having potential for long-term earnings, are above the flatline. Since 2007, growth has jumped 200% with value up just 40%.

While there will be some who are quick to point out that over a longer term, say 90 years, value has trumped growth, the underlying fundamentals that have given growth an edge over value during the past ten-plus years are likely to remain in place.

The Glorious Backdrop for Growth

Many have offered their take on why growth has outpaced value, pointing to the widening valuation spread between value and growth stocks, sector biases in value investing and lower-for-longer interest rates.

Financials and energy, which often hold the largest sway in value-investing strategies, are unlikely to make a comeback anytime soon.

Low interest rates, which have kept a lid on bond yields, has left banks struggling to turn a profit on loans and with the added pressure of Covid-19 related defaults, it's fast becoming apparent that money may be better served elsewhere.

Energy, meanwhile, is down by more than third over the past year, and notwithstanding the recent rebound in oil prices on output cuts, the crude demand story remains murky at best.

While the valuation spreads between value and growth stocks cannot continue to widen forever, there are not many who are betting on the global economy returning to rapid growth or interest rates breaking to the upside anytime soon.

In a low interest rate environment, growth stocks are "just mathematically worth more,” MFS strategist Rob Almeida told Barron’s. "So the terminal value for a growth company is higher, because of the discount rate, than it is for a cyclical company."