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Value or Growth? How About Quality

Published by Motley Fool Wealth Management on Tue, May 18, 2021
performance of factors through various interest rate environments

After the surprisingly resilient market last year, some investors expected their portfolios to be even more robust this year. That would make sense—the economy is much improved from the lows of the pandemic as it continues to reopen. But that hasn't been the case. Many of the stocks that worked well last year are not as strong now, even though earnings have not disappointed. For instance, the famed FAANG stocks—Facebook, Apple, Amazon, Netflix, and Alphabet (formerly Google)*—beat their first-quarter earnings expectations by an average of 41%.1 Yet on average, they've underperformed the S&P 500 this year—delivering just half of the return.2 So what's going on?

Fears of spiking inflation are spooking investors

We believe that there are three reasons these and many other stocks have fallen this year:

  1. Higher inflation will cause prices to rise and potentially influence the Federal Reserve (Fed) to increase interest rates sooner than expected.
  2. Consumer spending. Higher prices will impact the spending power of consumers. As a result, economic growth may slow.
  3. Rising inflation and higher consumer prices that may shut off the growth spigot tend to cause negative views of the future. Historically this leads investors to seek “safer” investments. For stocks, that has traditionally meant moving away from growth-oriented names towards value.

Most investors define growth as stocks that have the potential to grow faster than the market. Value, on the other hand, are stocks that are believed to be trading below their fundamental—or intrinsic—value. In the first three months of 2021, value has significantly outperformed growth. This trend started late last year but has accelerated recently.

email-chart-growth_value_3mo

But when you look back over the last decade, growth investing has been the place to be.

email-chart-growth_value_10yr

What's this mean for your portfolio?

The debate between value and growth is heating up, forcing investors to choose one side or the other. But we take a different approach altogether. We don't look at companies as value or growth. Instead, we seek quality. Our definition of quality seeks to identify qualitative business characteristics which we believe enable great performance across economic environments, regardless of which style is in favor.

We believe quality companies:

  1. Can raise prices
  2. Generate positive cash flow
  3. Have customer loyalty
  4. Maintain competitive advantages
  5. Do not rely on external sources to fuel growth

So instead of investing based on low multiples (value) or growth expectations, we look for companies that control their destinies and deliver returns to shareholders. Historically, these companies typically perform relatively well in all economic environments. As the graph below shows, a quality factors-based index delivered positive returns in all inflationary scenarios (each color represents a real rate range) during a 40 year period beginning in 1980, whereas san index based on value factors delivered negative active returns in low-inflation (<0%) environments and underperformed (relative to quality and momentum) in higher-rate (>3%) scenarios during the same time period.3 

email-chart-real_rates_vs_mean_returns

But at times, the market “throws out the baby with the bath water.” We jump at those opportunities to add quality companies at cheaper prices to our portfolios.

Positive action in a negative market

Despite our unique lens focusing on quality companies, our Personal Portfolios may—and do—underperform at various points in time. We understand that standing back as your portfolio loses value is never easy. Sometimes you are compelled to take action. Here are three strategies that seem sensible during a market decline:

  1. Diversify: Consider adding another strategy to your asset allocation. Including an asset class or investment that is uncorrelated—moves independently of other assets—to your portfolio may reduce your total risk.
  2. Consider purchasing stocks: Depressed stock prices—especially when the fall is unrelated to the companies’ specific operations—present opportunities to buy good companies at cheap prices.
  3. Review asset allocation: This period may shed light on your ability—or willingness—to weather market drawdowns. You may want to review your portfolio's allocation and shift towards a more conservative one if market declines are too nerve wracking.

Easing concerns

The rotation from growth into value—or vice versa—is not uncommon.4 Despite the normalcy of shifts like this, it is still disconcerting to watch your portfolio fall. But the key is to hold companies that you believe control their destinies. These companies will not outperform all the time—no company ever will. But we believe that they will grow faster than the market and drive strong returns for investors over the long term. While near-term volatility is hard to swallow, knowing that the market goes through bouts of volatility and tends to move higher over time—led by, in our view, quality companies—is comforting. In addition, recognizing that your wealth plan expects bouts of short-term volatility while driving towards your long-term goals should help ease your concerns.

 


 1 https://www.barrons.com/articles/apple-and-the-rest-of-big-tech-reported-blockbuster-earnings-why-their-stocks-went-nowhere-51619785440.

 2 S&P/Capital IQ through May 11, 2021.

3 https://www.msci.com/www/blog-posts/factors-in-focus-impact-of/02114302295. MSCI “factor” indexes are rules-based indexes (as opposed to traditional market cap weighted indexes) that capture the returns of systematic factors that have historically earned a persistent premium over long periods of time. A factor can be thought of as any characteristic relating a group of securities that is important in explaining their return and risk. Factor investing is the investment process that aims to the harvest the risk premiums associated with each factor. MSCI currently identifies six equity risk premia factors: Value, Low Size, Low, Volatility, High Yield, Quality, and Momentum.

4 Vanguard Dec. 31, 1983 through July 31, 2020

Disclosures

* Certain of our Personal Portfolio strategies may hold FANG stocks. The mention of specific holdings does not constitute a recommendation by Motley Fool Wealth Management (“MFWM”). Rather, the discussion of these companies is solely intended highlight current market trends.

This discussion is intended solely for the purpose of providing insight into how we are managing client portfolios in the current market environment and why we believe our investment philosophy and strategies are well-equipped to hold-up.

This discussion is intended for informational purposes only, and should not be relied upon as personalized recommendations, investment advice or financial planning advice. Should you need personal financial advice, we encourage you to speak with a financial professional. Much of this discussion will reflect our opinions, estimates and projections as of the date of this discussion, which are subject to change without notice. Of course, we cannot represent that any opinion, estimate or projection will be realized. In addition, charts used in the discussion were prepared by third parties or by using third party data. We believe that this data is reliable; however, we cannot guarantee this data’s currency, accuracy, timeliness, completeness or fitness for any particular purpose.

Access to MFWM is only available to clients pursuant to an Investment Advisory Agreement and acceptance of our Client Relationship Summary (PDF) and MFWM's Brochure (PDF - 204 KB). You are encouraged to read these documents carefully. All investments involve risk and may lose money. MFWM does not guarantee the results of any of its advice or account management. Clients should be aware that their individual account results may not exactly match the performance of any of our Model Portfolios. Past performance is no guarantee of future results. Each Personal Portfolio is subject to an account minimum, which varies based on the strategies included in the portfolio. MFWM retains the right to revise or modify portfolios and strategies if it believes such modifications would be in the best interests of its clients.

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