The market outlook doesn't look great with inflation burning buying ability, and corporate profits. Furthermore, central banks are getting aggressive on monetary policy tightening, and that’s likely to curb growth and cool the economy. Central bank tightening comes after years of accommodative policy, in which growth stocks had been performing well.
With earnings and valuations at risk, is it now time to shift back to value?
The shift to safety
As the risk of a downside increases in equity markets, investors usually shift to safer assets:
While the above are movements in asset classes, there’s also often a rotation seen within the equity markets.
What’s safer within equities?
While equities are inherently risky assets, relative safety can be found in several ways:
Large caps - these companies are well-established, have been in the business for years, are great at what they do, have products and services that are sticky or in demand, have the ability to absorb shocks because of their size, can raise funds when needed, often aren’t walking a tight rope, are managed by industry leaders, and are part of well-established markets.
Defensives - these are sectors like healthcare, which aren’t really impacted by macroeconomic trends to the extent that the others are. No matter how much prices increase, you will consume the medicines that are prescribed to you.
Value - stocks that trade at a price lower relative to their fundamental value, which can be determined by sales, dividends, earnings or cash flows. Essentially, stocks that appear to be at a discount!
What is value investing?
Simply - it is investing in stocks where the valuations are attractive.
Common characteristics of value stocks include high dividend yield, and low valuation ratios (PB, PE, or the likes).
That said, it doesn’t necessarily mean all stocks with low valuations though. Some stocks have low valuations because they deserve low valuations, and investors don’t really want to pay much of a premium to own them.
It means investing in stocks that are currently low on valuations, but deserve higher. Businesses that have potential, which can exhibit superiority, and can hence command higher valuations in the future.
In contrast to value stocks, growth stocks are companies with strong exhibited and anticipated growth. They trade at high valuations because everyone wants a chuck of their growth story.
How do you find value stocks?
Value stocks will typically have a bargain-price since investors currently see it as an unfavourable investment. They’re just unwilling to pay a high price to own the stock.
They trade at valuations lower compared to their peer set, or may even be in a sector that itself trades at lower valuations.
A good way to start is by forecasting earnings of a company that looks good to you, or that you think has the potential to grow at a rate faster than now in the future. This may come from knowledge and research.
When you then divide the stock’s current price with its future earnings (say earnings two years later), you will get the PE ratio.
Once you compare the PE ratio to that of the market, or other players in the same industry, you will know if the stock is undervalued or overvalued.
If you have an edge over the market in terms of being able to correctly identify companies that will have superior growth rates, but also at the same time trade at lower valuations, you will have identified the value stock.
Why not just stick to growth stocks?
In all probability, growth stocks have already been discovered. Their success stories are already known in the market, and there’s enough coverage about how fast they are growing. These stocks already trade at higher multiples.
In any stock, your returns are determined by how much the earnings grow over a period of time, and how much the valuation of a stock increases. In growth stocks, because they are already discovered, and trade at high valuations, you only benefit from earnings growth.
However, in value stocks, you have the potential of earning from both earnings growth and a valuation re-rating.
Growth stocks during tough times
When economic conditions roughen up, growth stocks take a larger hit. Their earnings growth gets hampered as the economy cools down, and along with that valuations also start to get eroded.
Moreover, this gets aggravated by the fact that for any growth stock, the price is made up more from valuations than earnings. So when valuations fall, more stock price erosion is seen.
Consider growth stock G, with earnings growing from 100 this year to 150 next year. The stock is trading at a forward PE of 50x. Stock price = 7,500. Economic conditions turn bad and the company’s earnings will instead grow to 125. Investors will no longer be willing to pay 50x for that kind of growth. They will probably pay 25x. Stock price = 3,125 (-58% returns).
Value in tough times
And now consider a value stock V, with earnings growing from 100 this year to 120 next year. The market thinks it will be 110, but you think otherwise. The stock is trading at a forward PE of 10x. Stock price = 1,100. The company actually delivers earnings of 120, and investors are now willing to give it a multiple of 20x. Stock price = 2,400 (+118%).
Even if the company doesn’t deliver 20% earnings growth because of the economic slowdown, and pulls off 5% instead, valuation de-rating will be minimal, since it is already trading at a dismal 10x. If it goes to 7x, stock price = 735 (-33%).
In short, the low valuations provide a safety net in terms of how low the valuations can go. At the same time, if you’ve identified a business that can potentially deliver earnings greater than what the market thinks, you’ve got a double tailwind of earnings growth and valuation re-rating.
Investors hence tend to move from growth stocks to value stocks when the going gets tough.