Equity Strategy: Growth Versus Value

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This article was first published for subscribers on October 22 and is now open for general readership.

By Greg Peel

Slow But Steady

Morgans is forecasting the US economy to ultimately grow by 2.5% in 2015. The forecast would be much better if not for the slump in energy sector investment, brought about by the collapse in oil prices. Investment in the sector has reduced by almost a third, offsetting steady employment growth elsewhere and an improving domestic economy driven by the recovery in residential construction and development.

Morgans believes, nonetheless, that by the end of 2015 the slump in energy sector investment will have run its course. It will not rebound, but remain flat, while ongoing investment in residential construction should provide for 2.8% economic growth in 2016.

The broker also believes that the fast-growing healthcare sector will catch up to residential in 2016, although the sector’s contribution to the economy is smaller.

Morgans believes markets are misunderstanding the Chinese government’s purchasing managers’ index (PMI) readings and erroneously assuming ongoing sector contraction (See: Why China’s Manufacturing Sector Is Not Contracting).  Sectors of China’s economy are actually growing strongly, particularly within services, with financial services the standout.

Moreover, softer growth in China’s state-owned enterprises is being offset by strong growth in the private sector, where Morgans believes government support aimed at improving productivity is apparent. Strong growth in disposable income further suggests Beijing’s goal to transition the Chinese economy away from exports and towards domestic consumption may now beginning to bear fruit.

Morgans is forecasting improvement in Australia’s economy to 2.4% growth for 2015, following an annual rate in June of 2.2%, rising to 2.8% in 2016. While countries in Europe would be satisfied with such a rate of growth, Australia’s growth rate needs to be higher, the broker points out, due to a faster rate of population growth and subsequent need to provide jobs.

At Australia’s current level of 6.2% unemployment, wage growth will continue to slow, putting more downward pressure on core inflation. Morgans believes this will force the RBA into action once more, and expects rate cuts in both December and March.

Stop Worrying

Citi believes the sheer enormity of the GFC and the end of the once much vaunted “commodities super-cycle” have left many investors worried about the future and wondering just where growth will come from. Concern about China’s economy and the knock-on impact into smaller emerging market economies has only added to the stress.

Yet unemployment has been falling in the US since 2009, Europe is on the mend and it seems unlikely the global resources sectors could drag the world down any further from here than they already have, barring anything totally unforeseen.

A lack of perceived political leadership in the US has also added to the woes, yet the US housing and auto markets are firing along and despite the big slump in energy sector investment, net US capital investment has not fallen out of bed, Citi notes.

Indeed, Citi believes that in feeling so depressed, investors are actually as wrong now in fear terms as they were in euphoria terms in 2007.

Hiring plans in the US appear positive and there is a greater need to lift wages to both attract new employees and retain existing ones. Lower household debt than back in those halcyon pre-Lehman days is supporting consumer spending, which (ex necessary healthcare) accounts for 54% of US GDP. Discretionary spending remains muted, suggesting to Citi there may be some pent up demand.

And the broker notes it typically takes around 18 months for the benefit of lower fuel prices to be apparent in economic growth.

Growth vs Value

Macquarie’s equity strategists are unlikely to paint on a smile at Citi’s behest, however. They believe that the Australian stock market is wedged between a weak global backdrop and a domestic backdrop “that will only look worse in six months”.

The recent correction has only brought the ASX200 price/earnings multiple back to an historical mid-range 14.7x rather than down into what could be considered cheap territory. This does not allow much of a cushion for earnings disappointment, Macquarie warns.

Recently the market has witnessed outperformance in “growth” stocks. Growth stocks are those typically in the process of exploiting new industries or products or other opportunities, thus offering earnings growth above the market average. Positive sentiment leads to higher PE multiples and lower dividend yields. “Value” stocks, on the other hand, are typically those not doing anything much new or wrong but which have seen their share prices knocked down for some reason or another, making them appear cheap on lower PE multiples and elevated dividend yields.

The simple rule of thumb in markets, albeit far from a mathematical equation, is that growth outperforms for a period as value underperforms and eventually the cycle turns and value becomes the new driver. Recently the local market has seen the rally in growth stocks begin to strain and value stocks start to find supporters. But Macquarie does not believe the rebound in value suggests the cycle is now abruptly turning. Outside of the falling Aussie dollar, the broker can see no meaningful signs that earnings are set to improve for value stocks.

The broker expects the ASX200 to remain range-bound for the time being between 4950 and 5350, with the potential to retest the lows. The broker can see the potential for a rally in the December quarter but believes portfolios should remain defensive.

Macquarie’s strategists are Neutral on the resource sectors, and see the big banks as tactical levers that can be played for either upside (earnings) or downside (yield). They are sticking with Overweight growth stocks, Overweight global industrials and Underweight domestic industrials.

It is important to note that a broker’s equity strategists take a “top-down” valuation approach, starting with the global economic outlook, then the domestic economic outlook, and then the sector outlook, before arriving at a valuation for a particular stock. Stocks analysts, on the other hand, are specialists in one sector and apply “bottom-up” valuations, beginning with an individual company’s earnings forecasts.

Thus just to confuse investors, it is common for a broker’s stock analyst(s) in one sector to have a Buy rating on a stock in that sector while the same broker’s strategists rate the sector Underweight. A “Buy” or equivalent rating implies “this stock will do better than the than the other stocks in the sector or market”. A strategist’s Underweight suggests “this sector will not perform as well as another sector”.

On the subject of growth stocks, UBS has taken the analysis one step further and looked at “quality growth” stocks. The broker considers quality growth stocks to be those among the large cap ASX100 index which are trading on the highest PE multiples, backed up by high price to book value multiples. High PE stocks with low P/BVs are usually cyclical stocks suffering depressed earnings outlooks.

Macquarie notes growth stocks have outperformed lately, UBS notes quality growth stocks have had “an unusually good year”. Just as Macquarie is not yet prepared to call a peak in growth stock outperformance, despite an apparent return to favour for value, nor does UBS believe the run in quality growth has hit a peak.

Economic uncertainty is pushing investors into favouring quality growth, UBS suggests, and shying away from value. (For example, resource sector stocks have seen some recovery but remain very fickle.) Lack of earnings growth for the overall market is also supporting preference for quality growth, and the lower currency is also proving supportive.

That said, a number of quality growth stocks do look stretched and will need to deliver on earnings expectations, UBS warns. The broker cites two examples of quality that do not presently look stretched, being CSL ((CSL)) and ResMed ((RMD)).

Morgan Stanley is not ready to dismiss a return to favour of value stocks, due to the “momentum” trade. If we step outside UBS’ ASX100 analysis we find a good deal of smaller stocks that had become overnight market darlings, but have more recently seen their wings clipped somewhat. Meanwhile, beaten-down resource names have certainly seen some recovery for the depths.

The momentum trade implies that if something is moving, get on. Momentum feeds on itself, such that the smart money sees the potential early and gets in, pushing up prices and alerting slower movers to the story. They pile in, the story feeds on itself, and then finally the Johnny-come-latelies cotton on, and buy in as well – usually from the smart money which is now taking profits. Then the bottom falls out.

By that time the smart money has already moved into the beaten-down names primed for a recovery. The cycle reverses, both in terms of growth versus value and momentum.

Morgan Stanley’s global team expects a sustained bounce in commodity/resource stock prices into year-end, on the assumption developed market growth will hold up and Chinese growth will stabilise, and because the market is very short.

For Australia in general however, Morgan Stanley is not so enthusiastic. The economy is growing at below trend, the property market is now slowing, the bank earnings growth outlook is subdued and while the market PE is back into middle ground, net earnings growth forecasts are negative, suggesting middle ground is overpriced.

Morgan Stanley has set an end-2015 target for the ASX200 of 5150.

Citi concurs that the earnings outlook form here is weaker than it has been in recent years, and not just in the resources sectors. Consensus forecast earnings growth for the market ex-resources in FY16 is 4%, compared to 6-8% across FY13, 14 and 15, subsequently delivered. Part of the problem is that those years featured a strong focus on cost cutting, but then a company cannot keep cutting costs forever.

Indeed, quite a few companies have now completed their cost cutting programs and efficiency drives, Citi notes, and only a few have announced extensions. That said, the broker can also identify a number of companies which are only now beginning to focus on costs, and have announced cost cutting programs. They number less than a quarter of the stocks under the broker’s coverage, but that number is not insignificant.

Citi thus believes that while earnings growth may well be more subdued in FY16, forecasts are modest and downside risks seem limited. One element Citi highlights revolves around those low commodity prices. Yes, their weakness has impacted on the Australian market. But their loss is also everyone else’s gain, from lower input prices at the industrial level to lower fuel prices at the household level, and there’s always a lag – 18 months in fact, as noted above.

Oil prices began falling out of bed in June last year.

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