Growth vs value investing: which will be the ultimate winner?

Growth stocks have outperformed value over the last decade, but what might the future hold?

It remains an exciting time to be a ‘growth’ investor, buying equities expected to grow faster than the market average. They are favoured by investors due to expectations their share price will be quickly boosted.

While growth stocks have largely outperformed ‘value’ in the recent high interest rate environment, the beginning of the interest rate cutting cycle could provide additional tailwinds for many of the market’s most innovative companies. Growth equities – represented by the Russell 1000 Growth Index – have historically outpaced value stocks – mirrored by the Russell 1000 Value Index – when the 10-year US Treasury yield has fallen below 4 per cent.

Even though there is a view that growth valuations are extended, we believe that is a misperception based on price performance, overlooking underlying earnings growth. They remain near long-term averages, with solid earnings growth expectations for the remainder of 2024 and 2025. (see Fig 1 & Fig 2)

Historically, growth stocks, which tend to grow organically and are less vulnerable to changing economic conditions, have outpaced value stocks, which are more sensitive to the business cycle, in a subpar economy. Stocks with durable earnings growth become more attractive as the broader economy slows, boding well for growth stocks in a slower growth environment.

If the Federal Reserve engineers a soft landing, lower discount rates could raise net present values on long-duration assets like growth stocks. This dynamic, combined with solid fundamentals and strong secular growth themes, would give global equities more room to run from current levels.

While macroeconomic influences can move equities fleetingly, dynamic growth from innovative forces outside the economic cycle – such as the rise of AI – offers ongoing opportunity as investors return to focusing on fundamentals over time. The generative AI-driven technological transformation will be as significant and long-lasting as the advent of the internet and mobile computing. The global AI market is expected to rise from $96bn in 2021 to $1.8tn by 2030.

Online consumption

AI and the super high-speed computing processing it requires continue to drive increased demand across chip and silicon companies. We are in the infrastructure build-out phase of the AI cycle, where requisite computing power needs to be established before applications can be developed. We continue to see substantial use cases expanding beyond technology providers and developers to a wide range of industries in the coming years and look forward to monetisation opportunities that will bring.

Elsewhere, while consumer spending on luxury brands is moderating globally, the trend does not suggest critical distress. As large, younger demographic populations with healthy disposable incomes reshape consumption patterns and generate persistent demand for luxury goods, leading luxury names from the ultra-high end of the spectrum are continuing to fare well. Online consumption patterns are now a major demand driver, with around 80 per cent of total luxury sales digitally influenced.

Chinese consumers account for the largest share of the luxury market, approximately 30 per cent, followed by consumers in the US – where demand began to soften last year. While China’s economic growth has weakened, we continue to see steady growth in the luxury category aided by strong demand from high end Chinese consumers travelling abroad. We continue to favour strong, global consumer brands with direct-to-consumer business models, and omnichannel distribution networks.

We also see select growth opportunities within healthcare, with strong potential in leading-edge treatments for diabetes, obesity, and rare diseases. Eli Lilly and Novo Nordisk currently dominate the obesity market, with demand expected to outpace supply for the next few years. Meanwhile, consumers are rapidly embracing powerful financial technology platforms, particularly in Latin America, where sophisticated financial services, and access to them, are limited. For example, neobank penetration in South America is expected to reach 20.1 per cent by 2027, far in excess of the 10.6 per cent in 2022. In addition, there are expected to be 292m digital commerce users in Latin America by 2028, more than double 2020 levels.

As interest rates start to fall, the backdrop remains favourable for growth stocks. While macroeconomic events – including stagnating Chinese growth, ongoing wars in Ukraine and Israel, and the US presidential election – may add to uncertainty, we continue to believe focusing on secular growth companies, with visible earnings and solid fundamentals benefiting from strong structural growth, represents the best way to navigate the uneven path ahead.

All investors seek the same goal – to buy a stock today and sell it at a higher price in the future. Both ‘growth’ and ‘value’ investors believe their stocks are ‘cheap’ at the time of acquisition, although value stocks are solely defined as trading at a price lower than the company is actually worth. In a similar vein, it’s unlikely any investor purchases a stock if they suspect company earnings are on a declining trend.

The point is every investment has value and growth characteristics. What determines whether an investment is successful is the price paid for the growth profile. If you overpay for a future earnings stream, or growth disappoints, you risk losing money – regardless how great the company is.

Microsoft in the dot.com era is a great example. It re-rated to 70x earnings as growth expectations ratcheted higher and higher to, in hindsight, unrealistic levels. In the aftermath of the tech wreck, Microsoft’s earnings continued to grow, but at a slower pace than previously expected, disappointing the market. The stock significantly de-rated. If you bought Microsoft in 1999 it took 15 years to recoup your investment.

There’s a reason for this history lesson. Growth has meaningfully outperformed value over the last decade and as a result, growth stocks are priced at a large premium. This is not new news.

But the valuation of the growth cohort relative to the world is at the top end of its 30-year range, while the value cohort is priced at its largest relative discount. This is interesting news. Even more interesting is that investors are prepared to pay 19x earnings for growth stocks, that are compounding earnings at 7 per cent each year, but only 10x for value stocks growing at roughly the same rate.

A nine-turn valuation premium is remarkable given minimal differences in growth profiles. Furthermore, the last time multiples diverged to this degree, the growth spread was significantly higher.

Moreover, six stocks – Nvidia, Apple, Microsoft, Amazon, Alphabet and Meta – have a combined share of 35 per cent of the MSCI AC Growth Index. History shows this degree of index or market concentration does not last.

Vulnerable profit pools

On top of this, these same six stocks account for 34 per cent of the MSCI ACWI’s gains over the last year. The case for owning growth today is increasingly dependent on performance of a handful of companies, whose own futures are inextricably linked to each other. It’s worth remembering the range of outcomes in the early phase of a disruption cycle are wide, and in a market-based economy large profit pools come under attack. Such narrow index concentration and narrowness of returns is a vulnerability, not a strength.

We’ve started to see signs of broadening out in market performance over recent months, but the case for a fundamental shift to value investing lies in the extreme multiple dispersion between value and growth equities, despite next to no difference in the growth profile of both cohorts, and extreme correlation within the growth cohort.

We expect value investing will trump growth, but we don’t believe investors should take a dogmatic approach to value investing and pile into the cheapest quartile of stocks with expectation of mean reversion. This approach misses structural change – where stocks are cheap because they are being out-competed, or worse permanently impaired, by their competition.

Just as it’s critical to avoid growth traps, such as Microsoft and co in 1999, it’s also critical to avoid value traps. A more pragmatic approach to value investing, where investors focus on paying the right price for a company’s business resilience and growth profile, will help avoid the classic value traps.