Market commentary equities: Bye-bye growth, hello value? We answer our investors’ questions
Many of our clients have asked us what positioning the various equity factors of our factor investing strategies suggest in the current market environment. Our portfolio manager Andjelka Bannes, CFA, shares and explains our findings on growth, quality, value and low-volatility equities in the context of dynamic markets.
Andjelka Bannes, CFA
Executive Director Equities
Scientifically based factor approaches have proven their worth in the active management of equity portfolios over decades, but are currently being challenged by the dominance of a small group of US mega-cap technology companies: The “Magnificent Seven” have a significant, if not distorting, influence on the major indices whose components are weighted by market capitalisation (such as the S&P 500). They are often underweighted in factor portfolios, which are generally constructed without reference to a benchmark.
However, if you want to invest successfully in the long term, you need to understand both short-term fluctuations and long-term trends. This dichotomy illustrates both the challenges and the opportunities that investors face. While factor strategies are fundamentally driven by specific historical data series over longer periods of time, a prevailing market sentiment often deviates and is influenced by current trends. Let’s take a look at some interesting questions that institutional investors are currently asking themselves.
Is it time to cash in on growth stocks?
After an impressive performance in recent months, there is growing concern that the market may be overvalued – especially for “expensive” growth stocks such as the Magnificent Seven. There is no doubt that the major technology companies have impressive fundamentals, such as high profitability and robust earnings growth over the past ten years, but the rapid rise in share prices has now outstripped earnings growth. This raises questions about the sustainability of such high returns. We expect future earnings growth to be more closely linked to overall GDP and inflation growth, which could have a significant impact on the growth prospects of large technology companies.
As shown in the chart below left, S&P 500 earnings are currently above trend. The chart on the right shows that earnings growth has been incredibly high (around 10%) since the global financial crisis of 2009. This growth was significantly higher than overall economic growth (GDP+inflation). This excess of more than 6 % is generally not sustainable and is likely to be significantly lower in the next decade.
Figure 1: US equities will find it difficult to build on the success of cheap money
In addition, the exceptionally high profit margins of the growth sector may be reaching natural limits; given the already high market shares, there are concerns about future sales growth rates. Indeed, correlations are already showing signs of weakness as Nvidia, Amazon and Meta rally while Tesla and Apple fall. In the past, when correlations start to wobble, it has been an indicator that a rally is running out of steam. However, timing such mean reversion remains extremely difficult and so far the technology sector, with its monopolistic structures, has continued to impress with robust earnings and sales growth.
Figure 2: Fundamental performance of the Magnificent 7 stocks
From a strategic perspective, the performance of growth stocks could be dampened in the coming years due to higher interest rates, greater financing hurdles and increasing uncertainty about the sustainability of high earnings growth and profit margins.
What is the outlook for quality stocks and what are the key industries and metrics to watch?
Unlike other factors, the quality style is not standardised across investment managers and index providers. It typically includes metrics such as profitability, margin indicators and measures of financial robustness, as well as some form of earnings stability. While profitability tends to be positively correlated with growth and negatively correlated with value, if we assume a potential weakening in margin growth and hence in profitability/quality strategies relative to previous trends (as highlighted in the previous section), this could lead to unexpected setbacks for high quality/high profitability stocks despite consensus expectations of positive earnings growth.
In our view, “quality” strategies often tend to overweight highly profitable (sub)sectors, as is currently the case with luxury goods stocks compared to cyclical consumer stocks such as automotive stocks. However, the influence of individual stocks often outweighs sector considerations (e.g. Tesla is favoured in the automotive sector, Nvidia in semiconductors). We conclude from this that individual stock effects tend to be more important than industry effects in quality factor strategies. With regard to such industry effects, there is again a lack of consensus on whether metrics should be adjusted or neutralised across industries (and countries/regions) and at what level (sector vs. industry group vs. industry). While most active managers implement some degree of neutralisation, the level of detail varies (e.g. neutralisation at sector level but not at [sub]industry level).
Given the economic outlook, what are your expectations for momentum factor strategies?
At present, our analysis suggests that the positive correlation between momentum and (expensive) growth stocks will continue. While this trend often leads to short-term gains, we see potential dangers if valuations become stretched. While short-term gains can be expected from the momentum style, the increasing risks emphasise the need for caution: there is a significant risk of substantial underperformance if earnings momentum in these stocks slows or falls short of (high) expectations.
It is also worth noting that some managers do not adequately neutralise sector, industry or country effects when applying the momentum factor, thereby amplifying the associated risks.
Given the economic outlook, what are your expectations for the value factor? Which sectors and key figures will have a particularly strong influence on the investment activities of the factor strategy?
By definition, the “value” factor is the counterpart to the “growth” factor (and to a certain extent also to the “quality” factor). As economic conditions are currently exceeding expectations, we believe that cyclical value stocks will flourish. This is especially true given the potential risks to growth stocks over the next 1-3 years. Similar to quality, value is often neutralised across regions and sectors/industries, although this neutralisation can be imperfect.
Normally, a value strategy tends to underweight the Magnificent 7, favouring cheaper semiconductor companies over an investment in Nvidia, for example. However, value stocks can face challenges in an economic downturn, with regional differences playing an important role. For example, the US economy could perform better than expected with a soft landing, while the economic outlook in Europe and especially in China could be weaker.
While the value factor in the developed markets is unlikely to suffer significantly, external factors such as the US elections or potential problems in the (commercial) property sector could present unexpected hurdles.
What are your expectations for the performance of the minimum volatility factor in the upcoming year?
To answer this question, it is important to understand the difference between a minimum volatility strategy and a low volatility factor strategy (also known as a low beta factor strategy). Unlike the latter, which assesses volatility at the individual stock level, the former operates at the portfolio level and aims to minimise both correlations and volatilities.
If you’re considering a long-only portfolio that focuses on the MinVol portfolio or low-volatility stocks, it’s important to note the defensive nature of this approach compared to long/short strategies. While low volatility doesn’t typically lead to outperformance within a long-only strategy, it does mitigate risk.
Historically, low beta equities have delivered returns comparable to the market – but with significantly reduced risk, even in the unfavourable market conditions following the global financial crisis from 2009 onwards. However, the dominance of a few stocks, such as the Magnificent 7, in the US indices and the MSCI World has presented a challenge for minimum volatility portfolios, even if they have performed well in emerging markets.
Figure 3: Realised return and risk for large caps US stocks, ranked by previous beta
In summary, the MinVol style could act as a hedge during geopolitical and macroeconomic deterioration and thrive when US big tech disappoints. However, current market sentiment seems to contradict this notion. Unlike value strategies, which are also betting against Big Tech, MinVol/LowVol should prove more resilient in an economic downturn.
Finding a balance remains key to navigating long-term trends and short-term signals in investment strategies
We are currently observing a clear discrepancy between the long-term data trends and the short-term market signals. Long-term probabilities favour value, small-cap and low/min-vol strategies, while short-term trends continue to favour quality, growth, large-cap and momentum. As economic signals improve, cyclical value/mid-cap stocks (though not necessarily those with low volatility) should perform well, especially in the second half of the year. However, political instability could lead to unexpected setbacks for cyclical stocks.
Given these uncertainties, we recommend a balanced multi-factor approach that avoids excessive exposure to any one direction. We advise avoiding obvious risks such as investing in unprofitable (low quality) growth stocks or overly expensive momentum stocks.
