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Growth versus Value stocks during the Pandemic

Updated: Aug 14, 2020

How has the Covid-19 pandemic affected investor preferences for growth versus value stocks and what does this mean for company directors and management?

Please note: The information and discussion below is not intended as investment advice.

You may have seen recent news articles and public comments noting the rise in the values of growth stocks relative to value stocks during 2020. Given that the pandemic has rattled economies and markets it is perhaps a little surprising that investor preferences would shift in this way. Past crises, like the GFC, witnessed a move away from riskier assets, sometimes described as "risk off" rather than "risk on". However, this time it seems the opposite is the case. I was curious to see this trend for myself and I'm sharing my analysis in this post.

Unexpectedly investors seem to have shifted to 'risk-on' Growth stocks and away from 'risk-off' Value companies.

What do people mean by Growth versus Value?

To my knowledge there is no widely accepted definition which delineates a Growth company from a Value company. For the purpose of this post (and the data underlying the visualizations below) let's suppose that:

  • Value companies trade at lower multiples of their fundamentals (e.g. revenue, EBITDA, eps), they exhibit lower growth (relative to Growth stocks) and their dividend yields tend to be higher.

  • Growth companies tend to trade at higher multiples of their fundamental results, naturally they exhibit higher growth rates, and their dividend yields tend be be lower.

Depending on the investor's risk appetite they may regard the high dividend yield currently paid by a Value stock as being less risky than the promise of future earnings in a Growth stock. Of course defining groups like this is a simplification of the underlying issues so be careful about reading too much into these arbitrary classifications.

What does the data say?

To investigate the trend I downloaded data for 700 publicly listed companies, drawn from Australia, New Zealand, and the United States. The two charts below show some initial results when looked at in terms of revenue growth versus dividend yield.

The data below is colour coded according to the change in market capitalisation from 31 January 2020 to 27 July 2020:

  • Darker blue indicates a larger increase in market capitalisation

  • Darker red indicates a larger decrease in market capitalisation

Charts 1 & 2: Five Year Revenue Growth versus Dividend Yield

Explanation of the charts

  • Chart 1 shows a scatter plot of the 700 companies (Aus, NZ, US) where each circle represents an individual company with its position plotted on the x-axis by revenue growth (5 year Compound Annual Growth Rate) and the y-axis by dividend yield (Last Twelve Months). If you position your mouse over the chart you can scroll in to zoom and click to pan (click the reset button on the chart if you get lost). Roll the mouse cursor over a circle and you'll see the details for that particular company. Each company's circle is colour shaded according to the % change in market cap from 31 Jan 2020 to 27 July 2020.

  • Chart 2 presents a heat map of the same data, where each square calculates the average change in market capitalisation.

  • The green dash lines indicate the median results for revenue growth and dividend yield.

Interpretation of Charts 1 & 2

Admittedly Chart 1 is a little noisy (position your cursor over the chart and scroll to zoom) but there does seem to be a little more blue in the bottom right quadrant, i.e. above median revenue growth and below median dividend yield. Same for the Chart 2 heat map. This means there's at least some support for the proposition that Growth stocks have outperformed Value companies during the pandemic

Focusing the data-set

Can we make this even clearer? Yes, by trimming the data down to more specific samples, as follows:

  • Growth stocks sample - those companies in the top quarter for growth, and bottom quarter for dividend yield (80 of the 700 companies).

  • Value stocks sample - those companies in the bottom quartile for growth and top quarter for dividend yield (61 of the 700 companies).

Chart 3 - Histogram of Market Cap Change (31 January to 27 July 2020)

Explanation of Chart 3

  • Chart 3 presents a histogram showing the distribution of companies according to their % market cap change during the period (the height of each bar shows the number of companies falling in each band).

  • Blue columns represent Value stocks and green represents Growth stocks.

Interpretation of Chart 3

The histogram demonstrates more clearly the skew of Growth stocks towards having a positive increase in market capitalisation (the median growth was 12%). Meanwhile Value stocks are skewed towards the negative (median decline -17% ). However, it is a distribution so some Value stocks did demonstrate growth, and some Growth stocks did post declines.

Given the pandemic why have Investors bid up Growth stocks instead of Value?

The analysis above shows what has happened, but explaining the why is a little more challenging. Never-the-less, here are some suggestions as to why:

  1. Fear of Disruption. 'All other things being equal' an investor would normally prefer companies with demonstrated earnings and dividends now, rather than future growth which has yet to be proven. However, perhaps things are not all equal in all cases. The business models of many mature companies are being disrupted by new entrants and innovation. In some cases this process has been accelerated by the pandemic which has affected supply chains, ways of working & leisure time. This fear of disruption might tip investor risk preferences in favour of Growth companies whose business models they perceive to be the future, even at the expense of some execution risk. [Likelihood: Likely]

  2. Lower Interest Rates. With the intervention of central banks (since the GFC and now again during the pandemic) the yield on government bonds remains at record lows. The knock-on effect of this may be that the discount rate applied by institutional investors to future cash flows could also have reduced, thereby resulting in higher valuations. Any reduction in discount rates will cause a greater uplift in value for Growth stocks over Value companies, since a greater proportion of Growth stock earnings lies further in the future (i.e. their future cash flows are now being discounted less). [Likelihood: Likely]

  3. Prominence of Retail Investors. The pandemic has meant that many people are now working from home and/or suffering from pressure on their regular income. This might lead more younger adults to invest in the stock market for the first time, whilst at the same time institutional investors may be 'keeping their powder dry' and waiting out the volatility witnessed during the first half of 2020. If younger adult investors have a preference for future growth (rather than current mature yield) then they may have bid up the prices for Growth stocks. [Likelihood: Possible]

What does this mean for company directors and management?

It would be wrong to infer too much from the analysis above but for what it's worth here are some thoughts:

1. Choose to worry about the things you can influence. There's nothing directors and management can do about low interest rates or the possible prominence of retail investors. The thing you do have some control over is the business model of your company and how it's being executed.

2. Don't stop investing for the future. In the current crisis cash flow is tight and almost all companies are facing difficult choices. Cutting items deemed discretionary spend is pragmatic but beware of cutting investment in your business to zero. The analysis above shows that public markets are placing a premium on growth (and perhaps wariness of disruption). This is not a time to be blind to the opportunities and challenges which lie in the future of your company. Perhaps big capital investments and transformations are off the table, but the precursors to successful big investment are small internal planning and innovation projects.

3. "This too shall pass". The public markets can't indefinitely continue to bid up the multiples of Growth companies. Eventually these expectations have to be earned out and the share price being paid reaches the present value of projected uncertain future cash flow growth. At some point this trend will stabalise or revert to a longer term average. The severity of the impact of the pandemic on our communities and the business world will also pass. Perhaps a vaccine will be discovered or countries will work together to stop its spread. When that occurs there will likely be a 'sprint' period as businesses rush to establish or re-affirm their position in competitive markets. Now is the time to plan for that sprint.

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