Episode 4 – Growth vs. Value Stocks

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Hello, everybody. Thank you for tuning in to <i>Market</i> <i>Perspectives,</i> a Mercer Advisors podcast where we provide a data-driven, common sense perspective on markets, on the economy, and on investing. I’m your host, Don Calcagni, chief investment officer at Mercer Advisors.

Today, we’re going to explore why growth stocks trade at a premium relative to the market. Alternatively, we’re also going to explore why value stocks trade at a discount to the broad market as a whole. But before we have that discussion, we need to first understand why anyone in their right mind would buy stock in a company to begin with.

And the only reason why you should buy stock in a company is because of earnings. Earnings matter. When you are an investor in a company, when you own equity in a company, you have a legal claim on that company’s current and future expected earnings to the degree that you are still a shareholder in that company.

And so it follows that the price of that company’s stock is a function of its earnings today and a function of how much we expect that company to grow its earnings in the future. And so today, we’re going to use a measure called the forward P/E ratio. That’s the price-to-earnings ratio.

Forward means that we are looking at the estimated earnings that company is going to earn over the next 12 months. So that, by definition, takes into account earnings growth over the next 12 months. And that’s really the key distinguishing factor between why an investor pays a premium for a growth stock or a growth stock portfolio versus why an investor would perhaps pay a discount for a value stock or a value stock portfolio. It comes back to earnings, and it comes back to earnings growth. So let’s actually look at some real-world examples.

The S&amp;P 500 index year-to-date is up about 12.7%.

That’s through yesterday’s close, June 8.

It trades at 18.5 times forward earnings.

Over the next 12 months, analysts are expecting, they are forecasting that S&amp;P 500 companies as a whole will grow earnings by about 5.3%,

so 5.3% in every dollar of earnings over the next 12 months. So $1 today. 12 months from now, will grow to $1.05 in earnings over the next 12 months.

Now, let’s look at technology. The technology sector is up 35% so far this year. So dramatic gains in the tech sector this year, coming on the heels of some really poor returns last year during 2022.

Now, the S&amp;P, like I said, is trading at 18.5 times earnings. The technology sector is trading at 26 times earnings. So it’s trading at close to a 40% premium relative to the market as a whole. That’s a pretty big premium that for some reason, investors are willing to pony up in exchange for owning stock in those companies.

So why is that? I said, it’s earnings growth. The earnings growth for the technology sector, according to FactSet, over the next 12 months, is estimated to be 7%.

So 7% earnings growth for technology companies versus about 5.3% earnings growth for S&amp;P 500 companies. So that extra 1.7% in earnings growth that’s expected, not promised, not guaranteed, expected over the next 12 months. In exchange for that, investors are willing to pay about a 40% premium for technology stocks relative to the broad market.

Now, let’s look at energy. Energy delivered phenomenal returns last year to investors.

But this year, its returns are negative. It’s down 5.5% year-to-date.

Well, why is that? Why is the energy sector down relative to other sectors and relative to the market? Well, the energy sector is trading, by the way, at 10.6 times forward earnings. So a dramatic discount. It’s actually trading at about a third of what the technology sector is trading at close to a third.

Why is that earnings growth for energy companies over the next 12 months are forecasted to decline by 15.8%?

So like I said, energy trading at 10.6 times earnings, trading at a big discount right now relative to the market, and trading at an even bigger discount relative to technology stocks, which are trading at 26.2 times earnings. Why? Well, because earnings growth is forecast to decline 15.8%. So it logically follows that investors are going to penalize energy company stocks because we’re expecting earnings to decline.

Now, one of three things can happen over the next 12 months.

One, earnings growth could come in as expected. And the prices of energy stocks and technology stocks today already incorporate the expected earnings growth. It’s already in the price.

All the investors in the market are fully aware of the earnings growth estimates for energy stocks and technology stocks. So earnings could come in as expected, in which case all other things held equal. We shouldn’t see any change in the valuation of these companies.

That’s a huge assumption. Obviously, there’s a lot of other things going on in the world–

geopolitics, interest rates, inflation, and so on and so forth. But holding all of that constant, if earnings growth come in as expected at 7% and negative 15.8% for energy stocks, then we should see no change in valuations for energy companies and technology companies.

So the second thing that could happen is that earnings growth could come in even better than expected. It could be that technology stocks grow their earnings by something more than 7%, in which case the stock price would rise. For technology companies, the valuations could even go higher than they are today. That would be a nice surprise, obviously, for investors in technology stocks.

Now, that would also be a nice surprise for investors in energy stocks if earnings growth only declined by, say, 10% instead of 15.8%. Well, that’s actually better than we were expecting, in which case, we should expect the valuations of energy stocks to actually rise because what it means is that we were too pessimistic initially when we were forecasting earnings growth estimates for energy companies. So that’s the second thing that could happen is that earnings growth could come in even better than expected.

The last thing is that earnings forecasts could actually disappoint. Technology stocks could perhaps grow earnings at, let’s say, 5.3% in line with the S&amp;P 500 expected earnings growth.

That could happen. They could disappoint, in which case, think about what that means.

Well, wait a minute. We were only willing to pay a 40% premium for growth stocks, in this case technology stocks, because they offered the promise of higher future expected growth. Now, if that higher promised future expected growth does not materialize and comes in lower, what it means is we were too optimistic in the beginning when we were putting together our forecasts for technology stocks earnings over the next 12 months. That means look out below.

The value of those tech companies needs to come down, because it’s only giving us the same earnings growth as the market as a whole, in which case, there’s no reason why we should pay a premium for those companies if they’re going to give us market like earnings growth. Now, when we step back and we actually look at the longer-term data, looking back historically, what we see is that value stocks actually deliver higher stock returns to investors than growth stocks. Not every time, not every quarter, not every year, not even every decade, but over long periods of time, what we observe when we look at the real-world data is that value stocks have delivered returns somewhere in the neighborhood of 2% to 3% annually, over and above the returns on growth stocks.

So what does that really mean? What it means is that analysts, when they are putting together their forecasts for companies’ future expected earnings growth, is that they probably tend to be a little too optimistic. And investors tend to be a little too optimistic when bidding up the price of those companies’ stocks.

So at the same time, we tend to be a little too optimistic with respect to growth stocks. And we tend to be a little too pessimistic when it comes to value stocks. And so the value stocks, intuitively, what it means is that they are exceeding their earnings growth expectations, which in this case energy negative 15.8.

Maybe energy does a little better than negative 15.8. Maybe it still loses money in terms of earnings growth over the next 12 months. But as long as it’s better than what is currently priced into the stock today, that could be a good thing for value investors. A little counterintuitive.

We’re always thinking growth, growth, growth. But growth in this context does not mean growth in stock prices. We’re talking about earnings growth. And if we’re too optimistic, when forecasting earnings growth for technology stocks or artificial intelligence companies, since they’re all the rage right now, what it means is that it’s easier to disappoint.

So for those value stocks, it’s easier to outperform. It’s easier to exceed expectations when we are perhaps overly pessimistic when it comes to forecasting their earnings over the next 12 months. But likewise, it’s easy to disappoint when we are perhaps too optimistic when it comes to forecasting growth stock earnings over the next 12 months.

So what does this really mean for real-world investors? Number 1 is that we should diversify broadly. You’re going to see a lot of noise in the earnings growth estimates and the actual returns in terms of earnings growth delivered by companies.

It’s a lot of noise in the data. So what do we want to do? We want to diversify broadly across all these sectors all asset classes.

Now, within those asset classes, the real-world data tells us that value stocks outperform growth stocks over long periods of time. So if you want to increase the expected return in your portfolio and if you are a long-term investor, it makes sense to overweight to tilt your portfolio towards value stocks. That doesn’t mean that you wouldn’t own growth stocks.

Of course, you would. We’re not talking about building a strategy that’s just 100% value. We’re talking about taking a globally diversified portfolio and then just tilting it, overweighting those value stocks in the portfolio.

So when you look at your portfolio today, and if you are already globally diversified and you already have a value tilt in your portfolio, just remind yourself that you still own those technology stocks. You just are not overweight those technology stocks. You own a lot more than just those technology stocks, but they are very much still there in your portfolio.

Well, that’s all for today. I’m Don Calcagni. Thank you for listening to <i>Market</i> <i>Perspectives.</i> And should you have any questions, please feel free to contact your advisor here at Mercer Advisors. Thank you, and we look forward to seeing you next week.

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