Value vs. Growth Stocks

Join us as we discuss Value vs. Growth stocks with Aneeka Gupta, CFA and Director of Research at WisdomTree. Aneeka touches on economic cycles, S&P 500, European perspective.

Summary – IBKR Podcasts Ep. 158

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Mary MacNamara

Hello everyone, I’d like to give a warm welcome today to Aneeka Gupta, who is the Director of Research at WisdomTree. Prior to the acquisition of Exchange Traded Fund (ETF) Securities in April 2018, Aneeka work as an equity and commodity strategist at the company.  Aneeka has 17 years of experience working as a research analyst across a wide range of asset classes. In her current role, she is responsible for conducting analysis for all in-house equity, commodity and macro publications and assisting the sales team with client queries around products and markets. Aneeka holds MSc in Mathematics from Oxford University and a BSc in Mathematics from the University of Delhi, India. She is also a Chartered Financial Analyst (CFA). So, thank you, Aneeka, for joining us today as we’re going to talk about value versus growth. So, I’m just going to start right in. What are some of the key differences of value stocks versus growth stocks?

Aneeka Gupta

Thanks so much, Mary. It’s a pleasure to be here today. So you know, just diving straight into it value, I think the concepts of value and growth were first introduced by Eugene Fama and Kenneth French back in 1992 when they were, you know, developing with Three-Factor model and that was really to help explain long term investment returns in excess of the market.

So, what Fama and French did is they actually defined value stocks as equities that have a very high book to market value ratios, and they defined growth stocks as those that have low book to market value ratios. So, the intuition here is that value stocks have low prices relative to their intrinsic value, i.e. their book value, but they are characterized by high dividend yields, and hence, they’re basically perceived to be undervalued. And in contrast, if you think of growth stocks, you know, they have the ability to grow their cash flows over time and generate a much higher return on assets in that way.

So that’s one way of looking at it, which is the traditional way. I think another approach of looking at it would be by via the net present value formula. So, if you think of growth stocks, they often derive a much larger portion of their value from cash flows further out into the future.  So, they may exhibit more sensitivity to changes in underlying interest rates, which will basically impact the denominator of those discounted cash flow calculations, and that’s really important. It’s quite timely in a sense to what we’re seeing today, you know, we’ve had expectations of very high Fed rate cuts and now we’ve finished the first quarter of the year, moving into the second quarter and that extreme optimism has moved to extreme pessimism.

And so, you’re now starting to see these well-known growth stocks dominated in the tech sector and the communication sector get to be on a shaky ground because there is a high expectation now that rates by the Fed are likely to remain higher for longer.

So, it’s really interesting to see, but and when you compare, you know, taking an approach of the net present value formula for value stocks. What you see here is value stocks cash flows are typically more evenly spread out and so that’s why they’re less sensitive to change in interest rates. So now that the new view is the Fed keeping rates higher for longer value stocks are doing a lot better on the equity market. So, you know that’s how I would view it. There’s a traditional way of just looking at the Fama French factor model or just looking at it from the perspective of how do you value these companies based on their net present value formula?

Mary MacNamara

So how did the market cycles affect the performance of value and growth stocks?

Aneeka Gupta

Yeah. So, you know, history tells us that the performance of growth as well as value stocks has been quite cyclical. You know, we’ve had periods of outperformance by value and value has historically tended to outperform growth. However, since the financial crisis, we’ve had growth stocks actually outperform value and I think that largely has been owing to the fact that interest rates have been very low, and as I mentioned, you know the net present value of these growth oriented stocks, their cash flows are being discounted at much lower rates and hence their value is a lot higher and hence investors are, you know flocking to growth oriented stocks.

So, I think the market cycle, the timing of the market cycle, the change in the economic cycle, I think it plays a dominant role for investors and their decision to pick value or growth stocks. You know, if you if you just reflect on 2022, we had a very sharp correction in global equities and that was primarily because of the onset of the Russia, Ukraine war and it was really interesting because here at WisdomTree we are very much a value oriented investment house and one of our flagship funds had done really well and you know the focus of that fund was typically on value.

So, while the rest of the market was selling off very aggressively, what we observed is value-oriented funds just outperform the market. They were the only, you know, funds to actually do well at a time when interest rates were rising, energy prices were very high, you know, commodity-oriented sectors were doing a lot better. You know that gives you an example of how market cycles have a really important impact on the performance of these value and growth stocks.

Mary MacNamara

So, what are some common misconceptions about value and growth stocks?

Aneeka Gupta

Well, I think I think the biggest misconception in my opinion would be to think that a particular stock is a value or a growth stock forever. I think that’s the biggest misconception because given the sharp change in the economic cycle, given the change, the rapid amount of change we’ve seen in technology, the advancement of artificial intelligence and the role it’s playing across industry, I think it’s very hard today to classify stock into a particular style or a factor, and then stick to that forever because you know there are many stocks that have evolved over time. There are many sectors that evolve overtime and I think it’s important for investment managers as well as investors who are actually looking into the market to observe the evolution of the stock that they are, they are interested in over, over the course of time.

You know, how is it evolving based on it could be ESG, it could be on the adoption of research and development.  It could be just embracing artificial intelligence, you know, into their day-to-day practice and that could have a significant impact on performance of the company. And likewise, you know the actual classification of that particular stock as a value or a growth stock.

Mary MacNamara

So how did the sectors of the S&P 500 relate to value and growth stocks?

Aneeka Gupta

Well, it’s been really interesting. I think we have seen some of the most severe distortions on the S&P 500 and we’ve witnessed that over prior cycles. We have seen what we saw in 2023 was that the US equity market, if you represent that by the S&P 500 benchmark index, the market lacked a lot of breadth, and by that, I mean, its concentration was very high. It was so high that in 2023, we virtually had the top five individual stocks contributed around 13% to the performance of the S&P 500. So, if you, you know think about in addition to NVIDIA and Microsoft, these top performers including Alphabet, Amazon, Apple, stocks in the magnificent 7. You know, they alone accounted for nearly 34% of the market cap of the S&P 500. And moreover, if you think about the market capitalization of the top 10% of U.S. stocks, that’s now back to just under 75% of the entire capitalization of the US equity market.

So, I think that distortion alone tells us that there is a change about to take place because valuations are quite excessive. You know the concentration of the market is very high, the expectation for 2024 is for breadth of the S&P 500 to begin to improve. I think another interesting observation for the S&P 500 especially what we’ve seen over the past year was those factors which are typical of growth should have clear, positive developments.

So, for example, you know those stocks with a high WAC, a weighted average cost of capital alongside high betas of much higher volatility versus the benchmark, you know that stood at about 17.2% and 16.8% respectively. On the other hand, companies that had lower earnings growth or lower beta to the market were clearly posting a lot poorer performance. So that was another very interesting fact that we saw on the S&P 500 over the past year.

And I think it’s interesting to see you know the sector concentration on the S&P 500 is actually telling us the story, because if we look at the stock market over a very long period of time, I think it’s easy to see that the sectors that were most important in the economic phase of the cycle we’re also playing the biggest role in in the S&P 500. So, if you think of, you know, the mid 1950s, it was dominated by the energy sector. Today it’s all about the technology sector and now and you know now we’re getting to see the size of the technology sector beginning to match what we saw of the of the peak for the energy sector back in the 1950s.

Clearly it remains smaller than the transportation sector, which again dominated in the 20th century or even financials and real estate that made-up most of the stock market in the 19th century. I think what we’re seeing take place is really interesting because the representation of these sectors on the index are virtually mimicking or mirroring the importance of that particular sector in the economic phase of the cycle.

Mary MacNamara

Very interesting. How can investors determine if a growth stock is likely to become a value stock in the future? So, let’s look at Apple. Is this still a growth stock?

Aneeka Gupta

Yeah, it’s a great example you mentioned.  You know, Apple is being one of the most promising growth stocks, but what we have been observing here at WisdomTree is the evolution of the stock has begun to change. You know, if you think about Apple, it’s viewed by some of the strategist as one of those well-known growth-oriented stocks. You know it’s been able to stand the test of time, mitigate periods of economic downturns, adjust its services and product offering.

So, it’s been a great choice for investors looking to maintain that shareholder value over you know, very, very long periods of time. But what we’ve now begun to see is, you know, Apple remains a reliable money machine. So, we know that, and it’s always been that way. It you know has very, very strong cash flow. What’s changed is dividend payments.  Dividend payments have played a very strong role in Apple’s share price and its movement. They initiated their dividend program back in 2012. They were signaling a shift towards returning value back to shareholders and you know those dividend payments have become really attractive to income-oriented investors. It’s essentially value oriented investors.

And so, with the company maintaining that dividend yield of .50% in December until December of 2023, we’ve seen, you know, that actually support its performance, its valuations. We’ve seen share buybacks also contribute to price growth by reducing total outstanding shares and essentially increasing the price, the value of the price you know per share. And it’s been doing so for every quarter until the end of 2023. So, while traditionally Apple is considered a growth stock, that change in the company strategy of introducing dividend payments and buybacks have positioned it as this perfect blend of growth and value.

So, I think the company’s now seeing mature product lines, it’s focusing on returning cash to shareholders. It’s reflecting that balance between growth and stability. And so, it’s really solidifying its, you know, its role as this blue-chip investment option within the tech sector. So, I think you know that’s an interesting one to pay attention to on how it, how it’s likely to evolve and progress. What I would say is, it is within this stage of an evolution. Which is why I would still classify it as a growth stock and one of the reasons is why it is showcasing, you know, a dividend payment, it introduced its dividend program back in 2012. It does offer much lower dividend yield when you compare it to income-oriented stocks.

And in addition, if you think about growth as we you know define in the in the beginning of the podcast, most of our growth stocks free revenue will be allocated to research and development of new products.  That’s a very important feature for growth-oriented companies. And as long as Apple continues to do that, yes, it is, it is distributing a very small share of its revenue. It’s giving back value to its shareholders, but that’s minuscule when you think of it in the grand scheme of things, where the majority of its free revenue is actually being allocated to R&D, research and development of new products. So that still classifies Apple as a growth-oriented share. But it is also, it also can be classified as that perfect blend between growth and value. That’s how I would put it.

Mary MacNamara

How can investors track the performance of a growth stock overtime to see if it’s becoming more like a value stock?

Aneeka Gupta

Yeah, so over time, I would say, you know, you can think of growth stocks as an expansion-oriented stock. So, a stock that’s really focused on building out its product suite, focusing on invention, spending a lot on research and development. In contrast, I would say value stocks are oriented towards providing more immediate benefits to investors.

And hence growth stocks are essentially operating on a foundation of very strong expansion, very strong innovation and that’s basically driving their performance in terms of earnings and market expectations.

Growth oriented stocks will always prioritize reinvesting their earnings to fuel their growth.  In contrast, value-oriented stocks will always focus on distributing all of that extra share of profits, you know as dividends back to their investors. So, I think that emphasis on revenue growth is key to understanding how that change is actually progressing.

If the stock that you’re holding, the stock that you’re analyzing is focusing on capturing and expanding market share staying ahead of industry trends, that is a pure growth stock.  That is a stock that is intending to grow irrespective of compensating their shareholder. And as a result, you see revenue streams tending to experience very strong expansion and it will reach a point where it can’t expand anymore.

You see it, you know, touching a peak. But until that point in time, it will be classified as a growth stock as it, you know, will often be outpacing the broader market. That’s what investors should be tracking. They should be looking at how that company is evolving its revenue growth stream. Where is it utilizing it? Into which sector of their, you know, active share of growth and if it’s really going into further expansion, you know staying ahead of industry trends, that means it should be classified very much as growth. But what they should be monitoring for, is that about to change? Are they now seeing a peak in those product lines sales. Has the company reached, you know, a level where now they believe it’s time to return that investment back to shareholders? And I think it’s once that we pass that phase that the stock moves from being classified as a growth stock to now a value stock.

Mary MacNamara

Interesting. So, we’ve talked about like the upsides of expansion and so forth. What are some of the downsides of building a portfolio with primarily growth stocks.

Aneeka Gupta

Well, I think you know 2022 would be the best example of the downsides of being too exposed to growth as a factor. You know, growth involves stocks that are very high beta. So that means they have much higher volatility, respected to the benchmark. And so when you have an unknown unknown event of a war taking place, the repercussions of that one event, you know, as catastrophic as it is a multiple because what we saw as an aftermath of the Russia Ukraine War was a jump in energy prices, a sharp rise in commodity prices and that was felt by consumers across the Globe, owing to which we had inflation levels rising and that eventually hit central banks across the globe. Central banks had to raise rates and growth being so sensitive to interest rates and inflation, you know, took the first hit.

So, I think that’s a very near-term example we can reflect on, you know, in terms of what happens when you get this sudden sharp, unknown unknown event over war. We even had went through the event of the COVID pandemic and everyone went into lockdown mode, completely unpredictable, very difficult to, you know, factor into any model that one is trying to design of a perfect equity portfolio. And there again, you know you have that well known example of trying to diversify your portfolio within growth as well as value.

I think investors have simply given up hope on value because they believe that since the since the great financial crisis, we’ve now entered a decade of very low interest rates, very, very low inflation and they expected that to continue for forever. And I think nothing continues forever. You do have mean reversion; we did get a very sharp jump in inflation and rates and subsequently you know sharp decline in growth-oriented stocks.

If investors were holding on to value, you know that would have put them in good stead. So, I think having a good balance of growth and value would be ideal in this, you know, given entering an era of very high geopolitical risks, very high uncertainty, political uncertainty as well. I think having that diversified portfolio would actually be a much better anchor to any portfolio as compared to just zoning in on growth-oriented stocks.

Mary MacNamara

Which countries would you access for pure value or growth bias?

Aneeka Gupta

Yeah, that’s it. That’s a really interesting question. I think here what does stand out is we try at WisdomTree to analyze the contribution of different factors via their excess return versus their underlying benchmark indices in US, Europe, Japan, Asia Pacific, ex-Japan, and emerging markets.

And what we observed was that in the case of the US, the contribution of value to excess return versus the underlying benchmark was very minimal. So, it’s very low. So, the US instead derived a lot of their excess returns primarily from two key factors and that was size being small caps and growth, growth-oriented stocks. They had a massive contribution to excess returns.

In the case of Europe and Japan, I think those two markets were quite interesting because that’s when we saw size exposure had a slightly lower contribution to excess return. Whereas value had much higher contribution to excess return versus their underlying benchmarks over time.

And when we compare that to Asia Pacific ex-Japan and emerging markets, the contribution of value was only slightly negative. So, I think the way we would look at it, the way we would distinguish between each of these markets is the US would be more of a growth-oriented market, whereas Japan and Europe are getting a higher source of those excess returns from value. So, they’re very much value-oriented markets. And in the case of Asia Pacific, ex-Japan alongside emerging markets, we’re seeing a much higher contribution of excess returns from value and growth oriented, so it’s a bit of a blend of both of those factors for these two markets.

Mary MacNamara

So how is the European equity market evolving from value to growth? Could you elaborate on the changes in sector weights?

Aneeka Gupta

Absolutely. So, it’s interesting because we’ve just spoken about Europe being very much a value-oriented market. That being said, I would say the profile of Europe stock market has changed significantly since the global financial crisis and to put it in numbers, financials is a sector still makes up, it’s still the dominant sector within the European market, but that dominance is beginning to erode. So, if I try to quantify it in numbers, we’ve seen the financial sector evolve from an overweight of 21% in European equity indices now coming down to about 17.5%.  

In a similar nature, we’ve seen the cyclical energy and material sectors, they have also been a bit in retreat, and you know the unexciting bond like utility sector has also contracted. So, if you think of utilities, they were quite high at about 13.1% and that’s actually come down close to about 5.4%. So, there has been pretty strong evolution there. If you look at materials, materials were much higher at 11% and that’s actually come down quite a bit to now just about 6%.

We’ve also seen other companies, including Infineon, again another semiconductor maker exposed to the electric vehicle eruption. Hexagon again, another one you know, thriving in geospatial measurement business, begin to really contribute to performance on the underlying index.

Now, I’ve spoken a lot about the evolving nature of value sectors that still remain quite dominant begin to decline and recede. However, at the same time, we’ve seen more growth-oriented sectors such as information technology actually double in size. So, if you think of the weight of information technology back in 2010 it was about 2.9%. It’s more than doubled. It’s now currently at 6.7% and growing in size. And if you know, you think about the stocks that have actually been contributing to that growth, we’ve seen very strong high-profile successes from ASML, a Dutch listed semiconductor manufacturing company.

Now another interesting sector, and this is where, you know, you see the changing nature not only of the stock but the underlying sector itself, healthcare.  Healthcare as a sector, its representation has grown almost 50% in the underlying European benchmark index.

The reason why I mentioned you can clearly see the changing nature of the healthcare sector is because the healthcare sector was always known to be this defensive corner of the market. However, now we’re seeing it widely recognized for its long-term structural growth opportunities and that’s because of emerging technologies as a backdrop of an aging global population that the world is facing.

And so, Healthcare is now becoming a lot more exciting. It’s got a lot more growth opportunities in it. And we’re also seeing that sector actually expand within the European market.  Other growth-oriented sectors such as consumer discretionary have really begun to garner momentum. In Europe, LVMH, Europe’s luxury brand, has, you know, constituents a significantly large portion of the index and clearly, it’s benefited from this, you know, boom in spending from the rising middle-class populations across emerging markets.

So emerging market economies, they’ve seen in a rise in wealth. The middle class has expanded and they’re coming over to Europe, to embrace the luxury sector in the European economy.

So, I think that’s another interesting one where consumer discretionary as a growth-oriented sector is beginning to gain in size not just because of the changing nature of consumption within Europe, but also as a beneficiary of the changing nature of consumption across the world, especially in emerging markets. So given that growth in healthcare, information technology, consumer discretionary and the decreasing relevance of financials, materials as well as utilities and energy, Europe is now adopting a more growth-oriented bias. It’s still in its nascent stage, but we are beginning to see that change take place.

Mary MacNamara

What advice would you give somebody who is just new to investing in value or growth stocks?

Aneeka Gupta

So, my biggest advice would be that you know you have to do your homework.

You have to do your research and you should never look at it in isolation. The world is changing. There are new risks emerging. You know, we’re entering a new era of geopolitical risks and that tends to bring along with it, a number of nuances, number of changes. We’re seeing, a lot of evolution take place within the technology space and that is being embraced by industries across the globe. And that is also changing the nature of a value or a growth classification. And hence I think it’s important to do your homework. Yet don’t completely rely on that. You know, be aware of the changes that are taking place globally and try to assess its impact on your underlying portfolio and I think that would put an investor in good stead.

Mary MacNamara

Thank you so much, Aneeka, that was excellent. That was a great conversation.

Aneeka Gupta

My pleasure, Mary.