Value, Growth or neither?Looking at equity markets as a conflict between Value stocks and Growth stocks has become a reflex for many market commentators. ‘Growth is beating Value’ (or the other way around) is always a good headline. Value stocks are defined as basically cheap stocks and it is, therefore, possible in any index, to point to the Value side of that index. Growth stocks are defined as stocks with above-average growth prospects. So again, it is possible to look at an index and point to the growthiest stocks. The main index providers have done exactly that by splitting their main indices in two down the middle, a Growth and a Value version, as early as the 1980s.
Using Value and Growth to explain the last ten years
While simplistic and playing into human’s love of false dichotomies, it is true that this narrative explained the last ten years of equity performance pretty well. From the overwhelming domination of Growth stocks, in a negative interest rate environment where investment was cheap, to the start of a Value revival last year, on the back of the most aggressive tightening cycle in decades.
What about the other factors? Didn’t Quality perform better over that period?
However, most things in our world can’t be reduced to a simple choice. Academics have demonstrated over the last five decades that multiple other factors can be used to slice and dice the markets to create outperforming portfolios. In the 90s, Fama and French introduced their 3-factors model using Value but also Size and Momentum to explain market returns. More recently, they added Profitability (often called Quality) and Investment in a new 5-factors model.
Looking at the performance of the seven leading factors over the last ten years, we note that while Growth beat the market by 1.6% per annum and Value underperformed by 1.9% per annum, the strongest factor was, in fact, Quality with an outperformance of 2.3% per annum1.
Is Quality Value or Growth, then?
Using Quality as a third lens, we observe that companies in the Value index are, on average, less profitable than those in the benchmark, and that those in the Growth index are, on average, more so. 23% of the S&P 500 Value exhibit less than 10% in return on equity (ROE) versus less than 5% for the S&P 500 Growth. And 25% of the S&P 500 Growth has more than 50% in ROE versus less than 5% for the Value index.
However, what is fascinating is that in the Value index, there are still some very profitable companies and in the Growth index, there are still some unprofitable companies. In other words, the Value/Growth dichotomy is very different from the High Quality/Low Quality one. The market could therefore be split not into two indices (Value and Growth) but into four:
High-Quality Value
High-Quality Growth
Low-Quality Value
Low-Quality Growth
Historically, High-Quality Value has outperformed High-Quality Growth
Using academic data, it is possible to splice US equity markets since the 60s into groups by fundamental data. In Figure 3, we focus every year on the 20% of the universe with the highest operating profitability (that is, High Quality in Figure 3). That group is then split into five further quintiles depending on their valuations (using price to book (P/B) as a metric) from the cheapest to the most expensive.
We observe that picking profitable companies with high P/B would have outperformed the market since the 60s but would have underperformed profitable companies in general. On the contrary, picking cheaper High-Quality companies would have outperformed both the market and the overall High-Quality grouping. In other words, Quality Value has outperformed Quality Growth over the last 60 years in US equity markets. Looking at other geographies, such as Europe, we find similar results.
At WisdomTree, we believe that a well-constructed Quality strategy can be the cornerstone of an equity portfolio.High-Quality companies exhibit an ‘all-weather’ behaviour that offers a balance between building wealth over the long term whilst protecting the portfolio during economic downturns. However, in 2022, secondary tilts were incredibly important. Value stocks benefitted from central banks’ hawkishness, leaning on their low implied duration to deliver outstanding performance in a particularly hard year for equities. Among Quality-focused strategies, the one with Value tilt delivered outperformance on average, and the one with Growth tilt tended to underperform.
Looking forward to 2023, recession risk continues to hang over the market like the sword of Damocles. While inflation has shown signs of easing, we expect central banks to remain hawkish around the globe as inflation is still very meaningfully above targets. The recent coordinated communication plan by Federal Reserve Federal Open Market Committee members is a further example of this continued hawkishness. With markets facing many of the same issues in 2023 that they faced in the second half of 2022, it looks like resilient investments that tilt to Quality and Value that have done particularly well in 2022 could continue to benefit.
Sources
1 Source: WisdomTree, Bloomberg. From 31 January 2013 to 31 January 2023. Growth is proxied by the MSCI World Growth net TR Index. Value is proxied by the MSCI World Value net TR Index. Quality is proxied by MSCI World Quality net TR Index. The remaining 4 factors (Min Vol, High Dividend Small Cap and Momentum) are also proxied by indices in the MSCI families.
NQFFUSQ trade ideas
During high inflation focus on high pricing power equities2022 continues to prove difficult for investors around the globe. The conjunction of heightened geopolitical risks, increasingly hawkish central banks, and runaway inflation has forced many investors to change tack and modify their asset allocation significantly over the last 12 months. Duration has been lowered across asset classes, and a survey we commissioned1 recently revealed that 77% of European professional investors use equities to hedge against inflation.
Fighting inflation by wielding Pricing Power
Not all equity investments are equal in the face of inflation. The key differentiator is their ‘Pricing Power’. Pricing Power describes the ability of a company to increase its price without impacting demand or losing market share to competitors. In an inflationary environment, margins are under pressure because companies ‘import’ inflation, whether they want it or not. Overall costs for the companies increase through labour, supply, or energy. The only tool to mitigate the impact of inflation on margin is to increase prices. Companies with Pricing Power will be able to do so the most efficiently. Certain types of companies tend to have higher Pricing Power:
Companies that deliver essential services tend to wield a lot of Pricing Power as they have somewhat captive clients. This is the case for many companies in the Consumer Staples, Healthcare, Utility, or Energy sectors.
Companies that deliver high-quality products or services and possess a distinct competitive advantage can also increase prices efficiently.
Luxury goods companies benefit from their clientele's relatively low price sensitivity.
Some companies can benefit from favourable supply-demand dynamics at a particular point in time. This is, for example, the case of semiconductors in 2021 or energy companies this year.
History is the best guide to the future
As is our habit when trying to assess the future, we turn to the past for guidance. The below graph focuses on US-listed stocks since the 1960s. It assesses the average outperformance or underperformance of different groupings of stocks, since the 1960s, when inflation is higher than the last five-year average. We observe that, on average:
High Quality stocks weathered inflation better than Low Quality stocks
Value stocks beat Growth stocks
High Dividend stocks outperformed Low Dividend stocks
Small Cap and Low Volatility did better than Large Cap or High Volatility companies
Overall, High Quality, High Dividend and cheap stocks appeared to fare better in high inflation environments.
The same analysis on sectors shows that Value-orientated, High Dividend sectors also tend to do better against inflation. Energy, Healthcare, Consumer Non-Durables (Food, Tobacco, Textiles), and Utilities exhibit the strongest average outperformance during high inflation.
It is clear here that the quantitative data aligns with our qualitative assessment. The factors and sectors that historically outperformed when inflation was high are those that have the greatest chance to harbour high Pricing Power companies. This should give investors indications on how they could tilt their portfolio to fight inflation.
Quality and Dividend Growth to fight inflation
In light of the unique challenges equity investors face, High Quality companies focusing on Dividend Growth could help strengthen portfolios. High Quality companies exhibit an 'all-weather' behaviour that tends to deliver a balance between building wealth over the long term whilst protecting the portfolio during economic downturns. Dividend-paying, highly profitable companies tend to:
Exhibit higher pricing power allowing them to defend their margins by passing cost inflation to their customer.
Exhibit lower implied duration, protecting them in a rate-tightening environment, thanks to a focus on short-term cash flows.
Provide a defensive tilt and an enhanced capacity to weather uncertainty.
Looking back at Equity Factors in Q1 with WisdomTree2022 opened with a sharp decline. The Ukraine War added further uncertainty to an already complex situation with entrenched inflation and upcoming rate hikes. In this installment of the WisdomTree Quarterly Equity Factor Review1, we aim to shed some light on how equity factors behaved in Q1 2022 and how this may have impacted investors’ portfolios.
- Value and High Dividend dominated in most regions.
- Pushed by increasing volatility and nervousness in the market, Min Volatility followed closely behind.
- Momentum and Size suffered mostly over the quarter, delivering underperformance across regions.
- Quality strategies delivered mixed results depending on their portfolio’s overall valuation.
Looking forward, uncertainty continues to rise, being economic or geopolitical. Investors face a trifecta of worries: rate hikes, inflation and volatility. Those market conditions should continue to favour value, high-dividend and quality stocks.
Performance in focus: Value and High Dividend lead the march
In the first quarter of 2022, equity markets took stock of a changing economic and geopolitical landscape. This led to a sharp decline in the first two months of the year, and despite a rebound in March, the MSCI World lost -5.2%. Unusually, the US and European markets delivered the same performance of -5.3%. Emerging markets lagged, impacted, in part, by the zeroing of most Russian stocks at the start of the war in Ukraine.
Q1 2022 factor performance has been driven by high inflation, the upcoming rate hike cycle and the Ukraine War. Faced with such a brutal landscape, some factors did well, some did not:
- Value and High Dividend dominated in most regions. They are the only factors that managed to outperform in all four geographies over the quarter.
- Pushed by increasing volatility and nervousness in the market, Min Volatility followed closely and ended up winning in emerging markets. Counterintuitively, it is in Europe that it did the worse.
- Momentum and Size suffered mostly over the quarter, delivering underperformance across regions.
Quality is an interesting case. The MSCI Quality indices used here as a proxy for the factor have suffered over the quarter, underperforming by 2 or 3% in developed markets. However, in this instance, the definition of quality and the criteria used would have hugely impacted the result. Quality, left unattended, tends to tilt toward growth (investors pay for quality, after all). This is the case for the MSCI indices and explains the underperformance in a Value-dominated market. Other ways to create quality strategies, focusing on profitability and dividend growers, for example, have fared better over the period.
Looking deeper into factors’ behaviour over the quarter, we notice two distinct periods. In January and February, markets' main concerns focused on rate hikes and inflation. In January, we saw expectations of the number of hikes by the Federal Reserve skyrocket. This led to a focus on low duration equities, away from high duration equities. Looking through holdings in different factors, this translates into tailwinds for Value and High-Dividend and quite large headwinds for growth. This is what we observe in the monthly returns, with Value and High dividend outperforming in both months. However, March saw a slight shift in perspective, with markets starting to worry about the effect of rate hikes on growth and the recovery. The inversion of the yield curve put an emphasis on such worry, and this led to the continued increase in market volatility. Therefore March saw a turn towards more risk-off assets with Min Volatility and Quality benefitting while more cyclical factors like Size and Value suffered more.
Factors, inflation and rate hikes
Inflation is back after a 15 year, if not 30 year, hiatus. In some way, markets and investors have forgotten how equities behave in an inflationary environment. As always, History is a very good teacher.
Figure 3 illustrates the average monthly outperformance of US equities organised by factor pairs in periods of above-average or below-average inflation. Historically, it is quite clear that
- High-quality stocks have created most of their historical outperformance compared to low-quality stocks in periods of higher inflation
- Similarly, value stocks, high dividend stocks and momentum stocks have also created more outperformance in periods of above-average inflation but less aggressively than quality
Implied duration is an interesting indicator of potential resistance to a rate hike cycle. Figure 4 exhibits the duration of equity stocks using a concept called ‘implied equity duration’, which measures the sensitivity of a stock just like the Macaulay duration measures interest rate sensitivity of bonds. It applies an extended duration calculation formula using forecasted cash flows for the company where cash flows are predicted using earnings and changes in Book Value. Stocks are then organised in equal-weighted quintiles depending on their estimated forward dividend yield or forward price to earnings ratios (“P/E”). We observe that:
- The quintile with the highest forward dividend stocks has the lowest duration on average, and the relationship is monotonic, with duration decreasing as the dividend yield increases
- The quintile with the cheapest stocks has the lowest duration on average, and the relationship is monotonic, with duration increasing as the P/E increases
In line with recent performance, this analysis points to high dividend and value stocks as being resistant to a scenario of rate hikes.
Valuations continue to come down across the board
In Q1 2022, valuations have decreased almost across the board for factors. Only high dividend stocks in Europe and emerging markets and value stocks in the US have seen a slight increase in price to earnings ratios. Size and Momentum have seen the sharpest drop.
Looking forward, uncertainty continues to rise, being economic or geopolitical. Inflation, pushed by commodity prices themselves stoked by the Ukraine War, shows no sign of slowing down. In response, Central Banks are turning increasingly hawkish, with the Federal Reserve planning to hike and reduce their balance sheet aggressively at the same time. This leaves investors with a triple worry: rate hikes, inflation and volatility that should continue to favour value, high-dividend and quality stocks.
World is proxied by MSCI World net TR Index. US is proxied by MSCI USA net TR Index. Europe is proxied by MSCI Europe net TR Index. Emerging Markets is proxied by MSCI Emerging Markets net TR Index. Minimum volatility is proxied by the relevant MSCI Min Volatility net total return index. Quality is proxied by the relevant MSCI Quality net total return index.
Momentum is proxied by the relevant MSCI Momentum net total return index. High dividend is proxied by the relevant MSCI High Dividend net total return index. Size is proxied by the relevant MSCI Small Cap net total return index. Value is proxied by the relevant MSCI Enhanced Value net total return index.
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
It is time to find out which companies have been swimming naked- Pierre Debru, Head of Quantitative Research & Multi Asset Solutions, WisdomTree Europe
A little bit over a year ago, President Biden was elected, and the cyclical recovery rally kicked into gear. Low-quality stocks (lower profitability, higher debt) that had particularly suffered earlier in 2020, benefitted the most and outperformed all other parts of the market. However, the Federal Reserve (Fed) may soon be starting to taper and has hinted at a more hawkish stand, and with increasing fear of a rebound of the coronavirus this winter, investors may start to be more selective with their investments. Such mid-cycle behaviours tend to favour high-quality stocks (high profitability, low debt). After a period where they took a backseat to their lower quality counterparts, such stocks could now benefit from their high pricing power and stronger balance sheets to help them face rising costs and compressing margins and help them potentially outperform.
Market timing the all-weather factor
At WisdomTree, we believe that quality stocks could be the cornerstone of an equity portfolio. We have often described quality as the all-weather factor that can help investors build wealth over the long term and weather the inevitable storms along the way:
- Since quality companies generate high revenues, they can grow and compound wealth in the future.
- Thanks to their solid business models and financial strength, they can withstand unexpected events such as an economic downturn or a pandemic.
Of course, no factor strategy is perfect and outperforms every day and in all market environments. Quality stands out among all factors because its periods of underperformance are relatively easy to identify and because this underperformance tends to remain pretty contained. Most factors can post double-digit underperformance in a short period of time, which has been less the case historically for quality.
Figure 1 shows the relative performance of the 30% most profitable US equities compared to the full US equity universe. Market drawdowns (in red) are periods of consistent, large outperformance. The relative outperformance line (in blue) increases, highlighting that quality stocks are performing better than the market as a whole. However, during the subsequent market recoveries (in green), low-quality stocks tended to recover faster than high-quality stocks, leading to some underperformance for the quality factor. The blue line goes down, meaning that the market is outperforming quality stocks. Outside of early recoveries and drawdowns, quality also outperforms quite nicely (the blue line creeps up), even if more slowly and usually towards the middle to the end of the business cycle.
A statistical analysis of the returns over the same period highlights the same pattern. High-quality stocks outperform:
- 56% of business days during market drawdowns
- 45% of the time in the first 12 months of the recovery (i.e. the 12 months following the bear market low)
When investors get picky, quality companies benefit
“Rising tide lifts all boats” is a famous aphorism that applies very well to the market behaviour in the first month of the economic expansion. Following a recession and a market drawdown, fiscal and monetary policy end up pretty loose, and liquidity flows to all corners of the economy. This pushes the prices of all companies up, in particular those of the companies that suffered the most in the crisis. This phenomenon usually leads to a low-quality rally at the beginning of the expansion cycle.
However, at some point, central banks turn hawkish, liquidity dries up, volatility starts to reappear, and investors start to get pickier when it comes to their investment. Investors start to look for solid companies with solid earnings and safe business models. High-quality stocks tend to benefit and see their price rise with increased demand at that point of the cycle.
Figure 2 exhibits the average annualised outperformance of high-quality stocks (defined as the top 30% by operating profitability in the US equity universe) versus the market over four distinct parts of the cycle. The National Bureau of Economic Research defines recession and expansion periods. Then each of those periods is split into two halves of equal duration. The quality factor’s outperformance is the largest during recessions. However, its outperformance in late expansion is also very strong, significantly better than in early expansion.
The latest two years fits that pattern to the T. Quality performed very strongly at the end of the previous cycle, i.e. in 2019 and in the early part of the Covid crisis in early 2020. Since the election of President Biden and the rollout of the vaccine, the low-quality rally has kicked into gear, and high-quality stocks have taken a bit of a back seat to the rest of the market. However, as we approach the first anniversary of the Biden presidency and with the Fed starting to taper and hinting at a more hawkish stand, it appears that the early recovery phase may be ending, especially in the US.
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
