Jason Kim, Portfolio Manager & Senior Analyst at Nikko AM Australia provides insights on recent trends in performance of value versus growth investing - and why he believes after a period of underperformance, value investing is set to return to favour.

The last two years, and in particular the 2015 calendar year, global financial markets have been in “risk-off” mode, with investors concerned about the lack of economic growth around the world, including Australia.

Stocks that have performed well during this period had the following attributes:

  1. High return on equity (ROE) – considered to be a proxy for “quality”
  2. High earnings per share (EPS) growth – considered to be a proxy for “growth"
  3. High dividends per share (DPS) growth – considered to be a proxy for “defensive growth” stocks.

In a “risk-off” environment, typically the focus on valuations falls by the wayside and many investors chase “safety” at any price. In this environment, growth and quality managers tend to perform well, while value managers typically underperform.

The chart below looks at the various financial markets around the world (including credit and equity markets) to assess whether the markets are assuming “the world is over” or “everything is rosy” scenario. This is about the psychology of investors, where fear and greed can drive markets, and where disciplined value investors can take advantage of this over time (although the timing may not be perfect).

Chart 1: Fear and panic dominating financial markets

Chart 1: Fear and panic dominating financial markets

Source: Credit Suisse

As chart 1 shows, fear or “panic” has dominated financial markets in the first few months of 2016. These extreme moments of fear and greed (“panic” and “euphoria”) do not last long, and eventually revert.

During periods of fear, investors chase quality, defensive growth and earnings growth at any price and drive valuations of these stocks to extreme levels as they are regarded as a safe haven, while shunning the rest of the market. These perceived ‘safe’ stocks can be driven so high in value that they become ridiculously expensive and even ’risky’.

Last year in particular saw this trend reach extreme levels (as shown in the following charts). Value managers have underperformed during this time, while growth managers have performed very well. However, we believe we could see this trend reverse soon.

Chart 2 shows the Price to Earnings (P/E) multiple of the stocks that offer dividend growth (eg Sydney Airport, Transurban, APA) relative to the market average. These stocks are seen to be high quality with growth in cashflows irrespective of economic growth. There is a price for everything, but they are trading at extremely lofty multiples. We acknowledge they are good-quality companies, but they are incredibly expensive and are trading at extreme levels which look difficult to sustain.

Chart 2: Dividend growth stocks trading at lofty levels

DPS Growth Portfolio PE Relative

Chart 2: Dividend growth stocks trading at lofty levels

Source: IBES, Thomson Reuters Datastream, Credit Suisse estimates

Chart 3 shows the same P/E relationship for those stocks with earnings growth (eg Dominos, Bellamy, Blackmores) and again they are trading at extreme levels - some are trading at around 60 times earnings and are priced for perfection as investors assume extraordinary growth over the next few years. The slightest disappointment will most likely see these stocks sold off heavily.

Chart 3: Earnings growth stocks priced for perfection

EPS Growth Portfolio PE Relative

Chart 3: Earnings growth stocks priced for perfection

Source: IBES, Thomson Reuters Datastream, Credit Suisse estimates

Similarly, chart 4 shows the P/E of ROE stocks, which is a proxy for “quality” stocks. This could include stocks already discussed above, but more generally are those companies that produce good earnings from limited capital outlay. Again they are trading at extreme P/E levels.

Chart 4: ROE stocks also trading at extreme levels

ROE Portfolio PE Relative

Chart 4: ROE stocks also trading at extreme levels

Source: IBES, Thomson Reuters Datastream, Credit Suisse estimates

Value stocks have taken a beating

Value stocks are currently those “beaten down” stocks in industrial cyclical industries where earnings and/or the outlook have been impacted by concerns about the economy either locally or globally. We currently see incredible value in industrial cyclicals. Examples include Incitec Pivot, Fletcher Building and CSR. In addition, many parts of the Financials sector (excluding REITs) now look very cheap, again due to concerns about the economy as well as financial markets (obviously related to each other), and they include the banks, Lendlease, Henderson and IOOF. We have recently been buying more of the banks and moved from an underweight to modestly overweight position.

The banks as a group (especially ANZ and National Australia Bank (NAB), and to a lesser extent Westpac) look very cheap and are trading at extremely low PEs relative to their respective historical levels. ANZ is at a 3 standard deviation low, NAB is trading at a 2 standard deviation low and Westpac is trading at over 1 standard deviation. The markets are jumping at shadows and the banks have been easy targets (up until recently) on concerns about China and concerns that the housing market will collapse, which have been exacerbated by highly-sensationalised media reports.

We often talk within our team about how the markets have forecasted seven out of the last four recessions. The markets will sometimes think the sky is falling in, but underestimate the will and the tools that central banks and governments around the world have to help address these concerns when they arise. Australia survived the global financial crisis relatively unscathed, but the equity markets had priced in quite the opposite scenario. Equally, concerns about Greece were overblown in 2011, with the European Central Bank implementing a host of policies to ensure that there would be limited contagion.

Looking ahead, we believe that not only will the Australian equity market be more constructive, but we also see the scene being more conducive for a snap back to value. Many empirical studies have shown that value investing has consistently outperformed growth investing over the long term - in both Australian and global equity markets. Our own analysis (Re-visiting the age-old debate on value vs. growth investing) shows that in the Australian equity market, value outperformed growth investing by an average of around 2% pa since 1989 (as at 31 October 2015) - and with less risk.