Thoughts from our Domestic Equity Team
In recent weeks, investors have witnessed notable underperformance in stocks classified as growth vs. those classified as value. Portfolio managers with a growth skew to their holdings have experienced the unfortunate reality of their stocks declining in the absence of any deterioration of fundamentals. At Roosevelt Investments, rather than consciously weighting the portfolio towards growth or value, we let our thematic views dictate the composition of stocks in the portfolio regardless of their growth or value attributes. Recently, our portfolio has had more of a growth tilt, which made it susceptible to this recent market rotation.
While one can be hard-pressed to explain short term stock market action with certainty, we have two theories which we believe may explain this performance discrepancy. First, at Janet Yellen’s recent inaugural press conference as Fed Chair, she suggested that interest rates could increase at a slightly faster pace than had been previously believed. While it is our view that too much was made of her remarks being a departure from prior policy, higher interest rates tend to have a greater impact upon growth stock valuations compared to value stocks. Conceptually, growth stocks can be thought of as having characteristics akin to long-duration bonds, with expected cash flows back to the owner further out in the future compared to value stocks. Long duration assets tend to be more sensitive to the impact of rising interest rates.
Second, we have observed that in many past market cycles, investors assign higher valuations to growth stocks when economic growth is scarce. But when economic growth picks up, growth stocks can lose some of their scarcity premium as investors gravitate towards a broader, more diverse group of stocks, including value stocks. During these ”handoff” periods, value stocks can outperform growth stocks. Just such a shift may be underway, and if so, the market is discounting it well ahead of any convincing macroeconomic evidence that the U.S. economy is entering a period of stronger growth.
We believe that many growth stocks have now sold off to the point that they are becoming interesting from a valuation perspective. A recent sell side note highlighted that most large biotech stocks are now selling close to levels which have historically represented good fundamental valuation floors. Biotech and pharmaceutical stock price/earnings valuations are now at similar levels, the first time this has occurred in a ten year span. Whether we are discussing biotechnology stocks or the larger cohort of growth stocks in general, keep in mind the reason investors have clamored for these stocks: the fundamentals of the companies in this group are considered to be attractive. In our view, in contrast to many growth stocks, many value stocks remain potential value traps, with business models threatened or under attack by growth companies. We believe that many companies at the value end of the spectrum are having challenges achieving even modest levels of top line growth.
In our view, there are a number of reasons to believe this growth to value rotation is not likely to persist. While we agree that markets often correctly discount shifts before they are fully appreciated by investors, signs of a shift to a period of stronger growth in the U.S. economy to date are largely absent. Much of the first quarter economic data has been negatively impacted by severe weather events in the U.S., and it will most likely be another month or so before we get more accurate readings of our current underlying economic status. In the coming weeks, many companies will be reporting their first quarter earnings, which will also provide more data to analyze for signs of growth.
We believe that the preponderance of this data is likely to show more of an incremental improvement in the economy rather than representing an inflection point towards a period of much stronger growth. If so, this should support the investment case for growth stocks and the scarcity of economic growth. Should the data herald much stronger growth ahead and a steepening yield curve that would be expected to accompany such growth, stocks in the industrial and financial sectors may benefit and help to offset any further style-related headwinds.
Submitted By: John Roscoe, CFA - Senior Portfolio Manager
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.