Value or growth? Here’s an analytical framework for decision making

Posted by Cam Hui -
Should you be a value or growth investor?

 

The accompanying chart shows the historical record. In the last 20 years, growth has handily beaten value. The U.S. value/growth track record closely tracked the international developed value/growth record until 2023, when AI-related plays in the U.S. went on a tear. Such stocks weren’t readily available in non-U.S. markets.

 

 

Does that mean you should continue to bet on growth investing or are value stocks about to have their day? Here an analytical framework to think about the value/growth paradigm.
 

 

The DA in EBITDA

Michael Mauboussin recently published an article that’s a master class on valuation techniques, focusing mainly on the P/E and EV/EBITDA multiples. One of the key points that he made is that not all EV/EBITDA multiples are the same. Investors need to distinguish between the EBIT and the DA in EBITDA. That’s because the DA in EBITDA is a proxy for the maintenance capital needed to maintain a company’s business. All else being equal, you should prefer a lower DA because it offers a higher free cash flow to investors.
 

The accompanying chart plots the EBITDA depreciation factor, or the DA in EBITDA, against the return on invested capital (ROIC) – weighted average cost of capital (WACC), which amounts to a first-order approximation of economic value-added, or the EVA concept originally promoted by Stern Stewart. As the chart shows, companies with higher DA tend to have lower EVA.

 

 

In plain English, these results mean that, all else being equal, asset-light companies with lower DA should trade at a higher multiple than asset-heavy companies. It just happens that in the last 20 years, the asset-light companies have been the growth stocks. They tended to be platform companies that engage in little or no manufacturing and rely mainly on intellectual capital to generate cash flow.
 

That’s been the secret of growth investing success.

 

This chart from Goldman Sachs documents how non-capital-intensive stocks have skyrocketed against their capital-intensive counterparts. That’s another way of distinguishing between growth and value stocks.

 

 

Mauboussin advised investors to focus on the DA in EBITDA in order to maximize the FCF available to investors. There is an additional detail in analyzing EBIT. Ian Hartnett of Absolute Strategy Research pointed out that EBIT margins tend to be higher in large-cap companies.
 

 

Putting it all together, the secret of past investing success has been an exposure to large-cap growth for its innovation and intellectual property, as well as its strong margins because of scale.
 

It would be difficult to suggest that investors should avoid these engines of innovation, but contrarians may find opportunities among asset-heavy stocks after a prolonged period of underperformance.

 

 

The cyclical opportunity

In the short run, however, value has outperformed growth across all market cap bands and internationally. That’s because the market consensus has pivoted from a soft landing to a no landing scenario of continued economic growth, even as inflation stays elevated and the Fed maintains its higher-for-longer interest rate policy.
 

 

 

Investment implications

Under the current circumstances, what should the equity investor do?
 

While growth stocks present long-term opportunities (see The Path to Magnificent Exuberance), the market is discounting an economic expansion with stubbornly higher than expected inflation, which will keep the Fed on hold. Given the higher duration, or interest rate sensitivity, of growth stocks, growth will face relative performance headwinds during this phase of the economic cycle. By contrast, the cyclically sensitive value stocks will enjoy relative performance tailwinds under these conditions.

 

I would advocate a strategy of holding an overweight position in cyclically sensitive value stocks, a market weight position in growth stocks, and an underweight in defensive sectors. Recession risk is relatively low during a mid-cycle expansion, and a commitment to defensive sectors is unnecessarily.
 

Callum Thomas pointed out that non-U.S. markets have a much higher cyclical exposure compared to the U.S., so it makes sense to raise non-U.S. exposure.

 

 

I prefer Europe and Japan, in that order, for cyclical exposure while avoiding emerging markets. European stocks have been in a choppy relative uptrend since last October, and should benefit from a global cyclical rebound. Japanese stocks recently achieved fresh all-time highs in local currency terms, but uncertainty over BOJ policy has weakened the Japanese Yen, which makes Japanese equity exposure problematic for unhedged foreign investors. The relative hawkishness of Fed policy is likely to put a bid on the USD, and USD strength presents significant risks to emerging market exposure, which I would avoid.
 

 

 

Timing the turn

While I am advocating a tactical overweight position in cyclicals and value stocks, how can investors time the turn back to growth?
 

Large-cap growth, as proxied by the NASDAQ 100, has been showing signs of relative weakness, but its relative performance is still in the middle of its historical normalized range. Should the NASDAQ 100 dip into the grey oversold zone, I would begin to raise the weight to growth.
 

 

More sophisticated investors with detailed quantitative tools can look for signs of changes in price and fundamental momentum, as measured by EPS estimate revision, to spot shifts in investment regime changes. If estimate revisions for value stocks begin to falter, and revisions for growth stocks are stock, that would be a signal to pivot from value to growth.

 

In conclusion, while growth has outperformed value for prolonged periods, I believe that cyclically sensitive value stocks present outperformance opportunities over the medium term. The U.S. economy is undergoing a mid-cycle expansion, which should benefit value over growth. By contrast, the high duration properties of growth stocks will present relative performance headwinds in a higher for longer interest rate environment. I recommend that investors maintain an overweight position in value, a market weight position in growth, and an underweight position in defensive sectors. In addition, aggressive investors may wish to consider overweighting small caps for their cyclical sensitive.

 

5 thoughts on “Value or growth? Here’s an analytical framework for decision making”

  1. What no recession or stagflation? The inverted yield and Friday’s economic numbers does show the economy slowing rapidly. David Rosenberg might ultimately be right.

    Technically speaking, I would watch the semi-conductor index and the transportation index.. In my book both are leading indicators of the economy. Both seem to have topped out.

  2. I hear you and this might be the time Value works best including Europe as a Value play. In the Mauldin conference last week a guru was asked his worst error. He said owning Europe because it was cheaper.

    America is fully and maybe foolishly/dangerously embracing A.I. while Europe is leary. Note that all cloud companies had huge sales gains in earnings calls. That is A.I. not family photos. Also big tech announced big cap ex. That is A.I. chips and data centers and by the way sales of Nvidia.

    A.I. makes asset light companies more efficient reducing costs. Think software and A.I. Copilots. Asset heavy companies less so. Value companies have a problem in inflationary times with higher wages and input cost increases. Growth companies are laying off people as they get more efficient with A.I.

    I’ve become a believer in the transformative nature of A.I. in so many areas. Maybe banking a Value sector will do great. A branch near me just closed. Dimon is embracing A.I. Maybe we should look at that type of Value that benefits from A.I.

    I am in momentum that will shift to whatever wins. We are in unprecedented times after the Sea Change.

    1. Price momentum is flagging. See the relative returns of MTUM and other momentum ETFs.

  3. Ken is right about what’s to come in the future, unprecedented. The first thing investors should to is ditching the old outdated classification of value, growth and cyclical. The only constant left is staples. US lost a big portion of industrial and material sectors during globalization. It is making a comeback with new types of operation, very heavy in IT and IP contents. And the old leftovers are too making fundamental shift of how operation is run. It is becoming increasingly difficult to just lump them in the old cyclicals. For example, a startup from Australia, Earth AI. This company has a very bright future and it will transform mining fundamentally, because of heavy use of data science and AI tools.

    Another example is Anduril from Costa Mesa, CA. This is a very young defense company specialized in autonomous systems, e.g. drones. It is beating out old stalwarts like Lockheed Martin in bidding for DoD contracts because of much cheaper pricing. It is in essence a platform software company, with investors from Palantir and SpaceX. So you get the drift. This is just another example of what the future will look like with AI algos and data science.

    The summary of all the reports I read in detail or just glanced, with some AI algo help, is that everything is going thru rethinking. This is fundamentally different from what we have in the past. The past is all about tool advancement.

    All we need is a stable environment provided by govs who should be restrained in irresponsible fiscal policy abuse. Let the game theory play out without gov handicap. It will be a very surprising new era. Stay invested. Things are going at the speed of electrons. Your fingers would not be as fast. And the mental aggravation will take a toll on you.

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