Growth to value, and back via quality

Inflation-fuelled stock rotations are full of complexity

The disruptive innovation of the 1960s was fast food. McDonald’s, the burger chain, was growing 20% to 25% a year. Its stock multiple rose to around 70 times earnings. Then something happened.

“Inflation broke out,” says Josh Jones, a portfolio manager with value investor Boston Partners. “Central banks had to fight inflation.”

McDonald’s continued to grow for the next eight years – still at the same rate. But its multiple concertinaed from roughly 70-times to 10-times. “The stock went nowhere from 1972 to 1980,” Jones says.

After a powerful rotation from growth to value stocks in the first half of this year, investors are thinking again about such cases – and about the long-term ties between inflation and investing styles. It’s a topical question, because many see high inflation lasting well into 2023. Some think central banks will struggle to contain inflationary pressures, perhaps for years.

Conventional theory – as per Boston’s Jones – says higher inflation would be ugly for growth stocks, and therefore broadly positive for long/short value strategies that short those names.

Growth stocks get hit hardest by the elevated discount rates that in valuation models are applied to a company’s future cashflows. Their valuations depend on more-distant future earnings. Inflation means rates going higher, which means deeper discounts, and so falling share prices.

History seems to support the argument. Data from Robeco running back to 1875 shows a long/short value factor returned 5.8% a year during periods when inflation went above 4% combined with falling 10-year bond yields, and 3.4% when inflation was high and yields were rising.

More recently, analysts at Research Affiliates plotted the ratio of value versus growth stock valuations – a measure that strips out the effect of wider markets moving up or down – to show that investors paid up relatively more for value and less for growth as inflation took hold this year.

An alternative to the pro-value narrative, though, says the outcome could be more nuanced.

In this view, inflation leads investors to favour so-called quality stocks – companies with pricing power and stable future earnings. That description fits some growth stocks too.

When inflation gets very high, it starts to destroy consumer demand, hurting cyclical businesses such as car makers and travel and leisure companies that typically sit in the long side of value portfolios.

“You don’t buy stuff because it’s cheap when the ship is sinking,” says Charles de Boissezon, global head of equity strategy at Societe Generale. “You want stocks that have got decent margins, decent pricing power, and you find many of those companies in the quality and growth segments.”

The US stock market tracked real earnings much more closely than nominal earnings in the 1970s, de Boissezon points out. In other words, investors were focusing on whether companies could withstand inflation. And growth companies typically deliver earnings with better visibility – one of the reasons they can be valued so highly using discounted cashflow models. Certain value sectors, by contrast, such as mining and metals, tend to have more cyclical and volatile earnings.

Recent events have underscored the complexities at play. A rotation in favour of value stocks this year reversed in mid-June with a resurgence of growth. Some bank analysts say, with all the uncertainty, they plan to look again at the data on inflation and equities in the coming months.

Rocketing prices may cause rotations from growth to value. Inflation that goes even higher could trigger a further turn – this time to quality, and back into growth. Stock market rotations, it seems, have the potential to go full circle.

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