The Valuation Gap Between Growth and Value, and How to Play It

The Valuation Gap Between Growth and Value, and How to Play It

A recent article in Barron’s reports that downtrodden value stocks are “finally winning” and the “comeback seems for real.”

The wide valuation spread between growth and value, along with the promise of fiscal stimulus, has driven up value stocks which, the article notes, are “generally weaker, more cyclical, or more economically sensitive than growth stocks.”

But the size of the valuation spread, it adds, “depends on which metric you use.” According to Research Affiliates founder Rob Arnott, the traditional price-to-book value gauge (which examines a company’s hard assets), is “currently at the peak of the [2000] tech bubble levels.” He adds, “so, I look on this as the first big step in what’s likely to be a long march back for value.”

But the article notes that book value doesn’t measure tech companies well, “as they often have little in the way of physical assets.” Another metric, known as the Shiller price/earnings ratio, smooths out earnings by averaging them over the past 10 years. According to Arnott, this metric shows growth stocks as “insanely expensive” versus value, which are “cheap, relative to the market, but not quite as cheap relative to its historic norms.” He argues that value stocks need to fall by 5% and growth by 50% to achieve fair value in accordance with historic norms.” For this reason, Arnott favors foreign stocks, especially emerging markets.

The article also cites comments from Davis Advisors chairman Chris Davis, who discerns between what he call “growth stalwarts”—like Google parent Alphabet, which he says has “incredible cash-generation ability” and a dominant competitive position—and more speculative names.  Davis looks for proven current cash flow generation over future cash flow projections.

The article adds that traditional value sectors can “benefit from rising rates, especially banks, which can increase profit margins on their loans by charging more for them as rates rise. Meanwhile,” it adds, “inflation should drive up prices of hard-asset-based energy, gold mining, and real estate stocks.”