What’s the growth stock story?

A market rally despite the COVID-19 driven recession

Since the dramatic share market lows of March 2020, the market has rallied by over 30% (S&P 500 – US Share Market). The rally has developed despite the ongoing pandemic and the global recession that occurred as economies ground to a halt to try and contain the virus spread.

The share market rally is similar in size to what we saw after the 2008 Global Financial Crisis (GFC) but, when we compare to the current rally, we can see a big difference in the sectors that have driven it. The current rally has primarily been driven by technology stocks, which are usually classified as growth stocks, rather than the cheaper value stocks.

During the post GFC rally both growth and value stocks picked up, with the value stocks rallying a bit more than the growth stocks. The current rally has been overwhelmingly driven by growth stocks and, at the time of writing, these stocks are well above their pre-COVID-19 recession highs while value stocks are well below.

Before we delve in to see why the rally has been different this time, it’s important to understand the differences between growth and value stocks in the following explainers.

Over time you would expect that value stocks would outperform growth stocks emerging from a recession, but this hasn’t happened this time around.

Growth Stocks

• A share in a company that is anticipated to grow at a rate significantly above the average growth for the market
• Companies that issue these stocks are usually wanting to reinvest any earnings they make to accelerate growth in the short term
• Investors tend to pay a high price for the ‘expectation’ of continued rapid growth
• Growth stock examples tend to be most common in the US technology sector and include Amazon, Facebook, Apple and Netflix

Value stocks

• A share in a company that looks to be trading at a lower price relative to their ‘book’ value - their earnings, sales and dividends
• Investors look at the financial fundamentals to assess if the market is underestimating the stock
• Value investing aims to profit from long-term investment in quality companies
• Value stocks can be found in many different sectors. Large global examples would include companies such as ExxonMobil, Coca-Cola, Cisco and the big banks

What’s going on? Are growth stocks being ‘over valued’ by investors?

The very strong and consistent profitability of growth stocks, as measured by earnings per share (EPS) is clear. If we look at the timeframe of pre-GFC (March 2007) until today (September 2020) the predicted profitability (12-month forward looking EPS) of growth stocks is more than double the level of value stocks.

Usually when we try to work out if stocks are cheap or expensive, we use more traditional metrics such as the conventional ‘book’ valuations of earnings, sales and dividends. At the moment, US growth stocks are showing to be too expensive (by around 25%) according to these estimates. But there are also many ‘quality’ factors, such as stable and elevated company earnings, which mean growth stocks may be around fair value (neither cheap or expensive). If we look at other valuation methods, such as comparing to bond yields, valuations are at or below fair value for growth stocks.

What will happen now?

The current rally has taken us into unprecedented territory when we look at the magnitude and leadership of the recovery and finding out whether growth stocks are currently cheap or expensive is complex. What isn’t in any doubt is that the share market will continue to be supported as economies heal but, as always, some short-term setbacks are likely, particularly until an appropriate vaccine can be developed. In the meantime, a longer-term well-diversified strategy using different asset classes including cash, property and fixed income, may be a more prudent approach.

In this complex and everchanging landscape, quality financial advice is key. Your adviser can develop a plan to help you to prepare for your financial future and support to keep it on track.

Dan Farmer

Chief Investment Officer

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