Since the start of the new year, uncertainty and fear from various external factors have sparked a market correction and a rotation of positive sentiment out of growth and into value equities. For most of the pandemic, growth stocks outperformed due to the incredible amount of stimulus and low-interest rates, despite the looming fear of COVID-19’s lasting impact on our society and economy. The abundance of monetary policy decisions may have given investors too optimistic of an outlook on the future. Low rates and trillions in federal spending cannot sustainably continue for long periods.
The Fed’s decision to wane off its spending and hike rates was needed to slow down the inflation caused by the COVID-19 stimulus. This is a large part of why value stocks have a higher sentiment than growth at the moment – inflation and rising rates lead to market uncertainty. Additionally, the developments in the conflict between Russia and Ukraine add to the worsening market sentiment and higher levels of caution from investors, catalyzing a rotation to value equities.
It is essential to clearly differentiate between value and growth when talking about this trend. Intelligent investing is the search for value in the sum of a company’s free cash flows generated over its lifetime. These cash flows are discounted to the present to understand the company’s current value. The opportunity for a value investment comes from searching for undervalued or cheap companies compared to their discounted free cash flows. Some speculation about the future is used in predicting performance for value stocks. Still, sensible forecasts use historical trends and data. Therefore, the range of possible outcomes for the investment is smaller than that of a growth investment, significantly reducing the risk of loss.
In contrast, investing in a speculative, or growth, stock comes with the ability to profit from the future value created by the company’s future growth of cash flows. The lifetime cash flows of the company are still summed and discounted to the present, except, since all or most profit lies in the future, the company trades at a hefty multiple of its current earnings in anticipation of future growth. Accordingly, the levels of speculation for growth investments are much higher than that of an intelligent value investment. Unlike value stocks, growth stocks have minimal amounts of concrete, historical information upon which to base their predictions for the future. Therefore, the risk factor associated with a growth investment is much higher due to uncertainty and a high dependence on unknown future performance. In a growth investment, risks of market share loss, cyclical downturn in demand, credit crunch, etc., are ever-present.
The technicalities of the differences between intelligent and speculative investments, or growth and value stocks, explained above can be simplified down into an example in real estate. For example, a value-based stock investment would be comparable to a rental apartment in Manhattan. The property is worth $1,000,000, located in a low-crime area with an abundance of nice stores and restaurants, and set to bring in $50,000 of annual rental free cash flow for the owner. This apartment is undervalued since other properties in the area are worth $1,500,000, and the rental rates can be formulated from the history of payments in previous years. In addition, the property will appreciate 5% annually, judging from the trends of appreciation in the area. With this knowledge, it is safe to believe that these trends will continue in the future. However, this is not to say the owner could lose money from the investment in the case of a fire or flood, demonstrating the ever-present risk in all forms of investing.
Property on the surface of mars provides an analogous example to speculative investment. Since the property is highly dependent on future growth, a $2,000,000 investment is required for purchase. At the time of payment, say there is no societal development yet on the planet and that nobody is willing to rent out the property. As space exploration and colonization become increasingly popular in the coming years, this investment could provide massive returns to the owner. However, it is still too early to know with any confidence. There are no previous trends or data to base the decision on; it is purely speculative with a lot of associated risk. As a result, one most likely would not commit to the purchase during a time of economic or political uncertainty.
After making the distinction and connection between value and growth, it’s apparent why the market has begun a rotation to value and the possibility for the trend to continue for the foreseeable future. Due to the high levels of speculation involved in growth investing, uncertainty in the economy, politics, business climate, or any other external factor can severely impact growth equity sentiment. During periods where this does happen, value stocks are seen as a safer, more intelligent investment since people want companies with a history of profitability that are also undervalued.
There is already a lot of guessing involved in growth investing, and factors like inflation, rising rates, and the conflict between Russia and Ukraine only increase the risk of wrongfully predicting the future cash flows of a company. Seeing the current market and the state of the world, an excellent environment for value to outperform growth now exists. These fears and uncertainty have led to an optimal market for value stocks.
Chairman & CIO of Ironhold Capital
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