Graph of the week

An important distinction in investing styles is the one made between growth and value. In a nutshell, growth investors are attracted to companies that are capable of growing faster than the rest, while value seekers are on the lookout for companies that are being undervalued. This generally tends to be companies with low growth expectations, meaning stock prices are fairly low relative to profit, the book value or another valuation measure.

Historical data reveals that in the long term, value stocks yield higher returns on average than growth stocks. Apparently, growth companies frequently fail to meet high growth expectations, whereas value companies often exceed the low expectations associated with them.

But this rule has not held true for the past ten years. In fact, this year in particular has underlined the strength of growth companies. The graphs above illustrate this point well by revealing the 12-month return difference between value companies and growth companies, as calculated by index provider MSCI. They show that in the past 12 months, growth stocks achieved 30% higher returns than value stocks for both developed and emerging markets. This difference has never been so profound in MSCI’s entire history of publishing these indices.

It goes without saying that 2020 has been an exceptional year and that there are good reasons for the astonishing performance of growth stocks. Typical examples of growth stocks are internet giants such as Facebook and Amazon, and Alibaba and Tencent in China. So, while much of the physical economy came to a standstill due to the lockdowns, the online world was running ahead at full steam. Meanwhile, ‘value’ sectors such as banks and oil companies had a tougher time of it. Investors are worried banks will have to sustain considerable losses if the economic standstill makes it difficult for companies to repay their loans. And even though oil prices have recovered and are currently at USD 40 per barrel, it is clear that long-term growth for fossil fuels is coming under increasing pressure.

So, the reasons for the higher returns associated with growth stocks this year are obvious, but some stocks really shot up. For instance, Chinese internet companies such as JD.com, Meituan and Pinduoduo saw their stocks more than double this year. What is more, just as Tesla in the US has seen its stock rise to 300%, many electric car companies in emerging markets have also done extremely well this year. For instance, Chinese electric car manufacturer NIO generated returns of 300%, and South Korean battery manufacturer LG Chem saw its returns rise to 100%.

It is tempting to compare these returns to those generated during the internet bubble in the late 90s. And we all know how that turned out: the bubble burst in 2000 and stocks of many growth companies crashed and burned. But, we need to remember that 20 years have passed since then, and the internet has become an integral part of our world. Internet companies are very robust now. It is therefore best to avoid making one-to-one comparisons.

What is comparable, however, is the widening valuation gap between growth and value companies. A year ago, growth companies traded at valuations averaging around 20x earnings, now this has risen to 30x. This is justified if future growth is high enough, but only time will tell if this will be the case. For now, it is safe to say growth expectations are high. The returns this year have set the bar considerably higher for growth companies to surprise us positively.