Changing of the guard
The unexpected surge in inflation caused considerable turmoil in financial markets in 2022, and as a result, both share and bond markets sold off significantly. However, somewhat beneath the surface, there was also a significant shift within the share market: the outperformance of value stocks over growth stocks.
This occurrence is probably less obvious to people who don’t follow markets closely, or who invest through a passive strategy, but it has caught the eye of investors interested in active management.
What are value stocks?
Value stocks are shares of companies that simply have lower valuation metrics than the overall market. Investing in value stocks is a strategy focused on the expectation that “buying cheap” will pay off over the long-term. It is a bit like saying that buying properties in a market with a higher rental yield – possibly away from the traditional centres – will give you a better long-term return than buying in, say, a more expensive market like Auckland.
Similar to the property market, there might be all kinds of reasons for why a particular company looks “cheap”. It could be, for example that a company is more risky or simply has a very poor future outlook. However, spread across many different companies, value investing has been extensively researched in share markets, and most studies conclude that it can outperform the broader market over the long-term.
Looking at historical data, it is fairly obvious that this can be extremely time dependent. Value investing struggled over the last decade – until very recently. This is because growth stocks were much more popular among investors during that time period.
What are growth stocks?
Growth stocks are typically shares of companies that are expected to grow at a relatively fast pace, much faster than the average company in the share market. Often these companies are in the technology sector, and some of them might try to delay profitability in order to grow their market share as fast as they can. This can be a recipe for success, as a company like Amazon demonstrates, however, there are many companies where expectations of future profitability turned out to be wrong.
Buying growth stocks is a bit like buying in the hottest property market, expecting that this is where prices will continue to rise the most. Maybe that will turn out to be the case, but sometimes it also worthwhile to focus on the price you pay.
Growth stocks have been the clear leaders in the share market until recently, in particular the stocks that were referred to as the “FAANG stocks”: Facebook (now known as Meta), Apple, Amazon, Netflix and Google (now Alphabet).
Does it matter that much?
The annual difference in performance between value and growth stocks can be significant, as the chart below illustrates.
If you have followed markets for a while, this chart may bring up some memories of past swings in markets. The last time value investing was declared dead – as it turned out, prematurely – was during the infamous “dot-com bubble” of the late 90s, where internet and telecom stocks were hyped up to astronomical levels. However, this ultimately reversed and growth stocks came crashing down in the early 2000s.
These swings in growth and value investing should therefore not be unexpected, but they might catch you off-guard if you do not understand your fund manager’s approach.
Changing of the guard
Here in New Zealand, we have clearly noticed the limited number of fund managers with a focus on value stocks over the last 5 to 10 years. This is not surprising, as past performance can be a great selling point for any investment product.
But with value investing becoming more successful now, we may be at a crucial turning point: a changing of the guard, so to speak. Fund managers with a growth focus might soon decline in popularity and global value managers could rise from the ashes. This could result in significant changes in the investment products held by the average investor in New Zealand, and perhaps even affect KiwiSaver.
What is the right answer?
Before you blame your fund manager, it is probably worthwhile to understand whether their underperformance was due to a change in the market environment, or due to a lack of skill. What market environment will present a tailwind or a headwind for their investment approach? Understanding the approach that they follow and what influence it has on your total portfolio is usually a good starting point.
This is also where thorough manager research can make a difference, as the devil is often in the detail with fund manager performance. Alternatively, you might just decide to follow a passive approach, and not worry about these differences at all.
Most investors have clear views on what approach fits their preferences. This is often the best starting point for a conversation. If a property investor does not believe in “do-ups”, they probably should not buy those properties. The same is arguably true with any investment: if you do not believe in an investment approach, it may be best to avoid it altogether.
Once you understand your preferences, you should undertake research on the fund managers that suit your approach. Most importantly, remember that past performance never guarantees that a certain trend or style will dominate forever. Otherwise, you might end up getting caught in the changing of the guard.
Past performance is not necessarily a good indicator of future returns.
Makao Investments is a New Zealand-based wholesale investment advisory business that was founded to lift investment advice to a higher standard.