In our most recent newsletter, we covered the great inflation debate that began during the first quarter of 2021. Inflation fears triggered a pronounced rotation out of growth stocks and into value stocks. We wanted to expand the conversation over here on the blog side of the website and briefly talk about why this happens and explore what is value, exactly?
Why the Rotation?
The basic rationale is this. Inflation and rising yields erode the value and purchasing power of future cash flows owed to an investor. For the growth equity investor, that means a higher discount rate is used, which is a critical factor, in determining the present value of future cash flows the company is expected to produce. A higher discount rate means the future is worth less. For the fixed income investor, those interest payments in the out years that you are entitled to receive, well, now they are worth less. Either way you slice it, the market doesn’t want to hold an asset that they have to pay a high premium for just to receive distant cash flows that are now worth less. Instead, they can rotate into assets that will be able to generate substantial cash flows right now or at least in the immediate future.
What is Value, really?
To start, let’s work off the premise that the goal of investing is to make money. We’ll define this as an investment of money is made today with the belief the purchased asset will be worth more in the future which can then be converted back into money. From this premise, we’ll pose a question, why would an investor buy a stock at a price they believe is a terrible value? It’s not a trick question. Our answer is, they knowingly wouldn’t. We believe an investor buys a stock, regardless of its growth or value label, because they believe it is under appreciated by the market and the assumptions baked into the current price do not accurately reflect the future cash flows the company will be able to produce over a timeframe suitable to the investor. That timeframe might be inside the next 3 years or it could be in 20. Therefore, in this sense, all stocks are capable of exhibiting characteristics of value. It doesn’t matter what the label is on the stock, growth or value, or what sector it is in.
Continuing this thought exercise, all stocks are also capable of exhibiting growth characteristics. To illustrate, look at the traditionally labeled value sectors such as Financials and Energy during the first quarter. The market was forced to respond to the upward revisions of revenue and earnings based on the expectations of growth from consumer demand with the world reopening. The result – these sectors shot higher in price. In other words, these value sectors were now viewed as an attractive area to participate in accelerated growth of near-term cash flows despite the fact they are clearly not growth stocks per traditional classification. But that doesn’t matter right now, value is the new growth, especially with fears of inflation and rising rates on the mind of the market.
If our assessment is accurate, we should also see growth become value as well. Spoiler alert, we already have. As the month of April has gotten underway many of the growth names, specifically in the Information Technology sector, have come back to life and begun outperforming value once again. Ironically, it appears as though investors believe these growth names were too cheap, they sold off too much during the rotation and now, yes, they are viewed as an attractive place to find some value.
After reading this, you would be correct in thinking the market speaks out of both sides of its mouth; it does. In our opinion, it’s because Wall Street is too fixated on the short-term which creates dislocation between the price of a stock and the value of the underlying company. Once you add in market dynamics such as speculative trading, shorting of stocks, news media and the prevailing culture of immediate gratification, you end up with quite the recipe for volatility. At AIMA, we are not concerned about a few weeks or even quarters. Our focus is on the long-term and helping our clients take advantage of the wealth creating opportunities that history, as a guide, tells us comes to the patient investor.