Even if the rotation has legs, stick to this golden rule of investing

There’s been much talk of the ‘reflation trade’, but investors should not entirely ditch growth for value.

There’s a growing chorus of investors arguing that the time has finally come for value shares to have their day in the sun again.

Prior to the Covid-19 pandemic, various commentators and value-focused fund managers talking up their own books argued that the valuations of growth stocks had become too rich following a 10-year spell of significant outperformance. It was argued that, at some point, the market would rotate towards the cheaper price tags attached to value stocks.

Then along came the pandemic, and with it an acceleration of various technological trends that fuelled a rally in the share prices of tech-savvy growth shares. Value shares remained out of favour with investors. 

Now, predictions of a resurgence in value investing are being made following positive vaccine progress. In turn, this could be positive for the global economy as businesses re-open.

Alongside the global economy accelerating, the spectre of inflation picking up has prompted plenty of column inches to be dedicated to the ‘reflation trade’.  In theory, this would be a favourable backdrop for value stocks that are more cyclical and economically sensitive, such as retailers, oil companies, airlines and housebuilders.

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While this could well play out - there have been signs of this trend over the past couple of weeks - it does not mean that investors should switch entirely out of growth and into value.

First, it is impossible to time. Those who made the switch a couple of years ago will have missed out on the continued strong returns of companies classed as ‘growth’.

Second, even if a rotation takes place there will be winners and losers among both growth and value shares – they will not all go up, and all go down.

On this point, Nigel Bolton, co-chief investment officer of fundamental equities at BlackRock, notes that “because this isn’t a normal recession, many of the winners over the past decade should keep winning – and continue to benefit from trends accelerated by the pandemic”.

Therefore, technology shares and other growth companies could continue to serve investors well. Bolton expects e-commerce companies and firms that help with digitisation to continue performing well.

Colin Mclean, managing director of SVM Asset Management, agrees that there will continue to be growth winners. He notes: “A sharp economic rebound over the next two years, coupled with higher commodity prices and monetary stimulus, is creating a stronger upward pressure on inflation – more than we saw in the aftermath of the financial crisis.

“This is likely to reduce valuations on highly rated growth stocks and will give a boost to surviving cyclical businesses that would otherwise have little pricing power. The rotation to value seems likely to continue in the coming months, although growth businesses focused on resilience and sustainability should see continued demand.”

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But there will be growth losers, meaning that the rising tide that has benefited various companies may be no longer lift all boats.

Bolton says: “One area of caution is that not all growth companies – companies that grew in an environment of low global growth over the past decade – will keep delivering for investors.

“There is not necessarily anything fundamentally wrong with these companies, but some disruptive growth winners with little cash flow or profitability have performed extraordinarily well over the past year – and may be vulnerable as investors spy returns in previously under-owned sectors and parts of the world.

“Of course, our view is reliant on the global vaccine programme being a success – and our base case remains that it will be.”

Rather than picking one style over the other,  it is much more prudent to own a mixture of both styles over the long term and stick to one of the golden rules of investing; diversification, which helps to reduce risk.

As our columnist Ian Cowie put it recently: “The fact remains that you cannot call your portfolio diversified if all its constituents are going up at the same time.”

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Craig Baker of Willis Towers Watson, head of Alliance Trust’s investment committee, cautions against trying to call or time a market rotation.

Alliance Trust (LSE:ATST) is style neutral, with some its nine fund managers favouring growth shares and others preferring value names.

Baker notes that Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Alphabet  (NASDAQ:GOOGL) contributed 45% of the MSCI All Country World Index’s 12.7% return in 2020.

Going forward, he expects share price performance to broaden across countries and industries as the global economic recovery takes hold. But this will not necessarily be at the expense of the growth winners in recent years – most notably the tech giants.

“We could see the tech giants continue to perform well, they are highly profitable businesses. The stock-pickers in our portfolio do think there are certain growth stocks that have bubble characteristics, but not growth as a whole. There’s an opportunity for growth and value fund managers to do well as the global economy gains momentum.”

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In the event of a sustained cyclical recovery playing out, this will theoretically bode well for UK equities, which have long been out of favour.

George Efstathopoulos, portfolio manager at Fidelity International, notes: “Although the Bank of England has cut its 2021 growth forecasts, they still suggest a successful vaccine roll-out will pave the way for a rapid recovery in the second half.

“That bodes well for UK equities. The market has a large share of growth sensitive sectors such as energy and banks, which have the potential to do well as reflation gathers pace. Forecasts suggest the recovery in UK earnings could be the strongest among developed markets.”

There are some early signs that investors are starting to return to the UK market. Figures from Calastone, the global funds network, found that UK equity income funds received inflows of £145 million in February. This ended an eight-month long streak of outflows – where more money was withdrawn than invested.

Efstathopoulos adds: “Flows into UK equities have also started to pick up, creating a technical tailwind. Importantly, defensive sectors such as consumer staples and healthcare also have large weightings in the stock market, offering some protection if the reopening is slower than expected.

“UK dividend yields may also begin to appeal. UK dividend futures fell recently, suggesting that payouts are still under pressure and could lag those in other regions. But some UK companies, including telecoms and commodity-related businesses, could start to divert free cash flow towards dividends again as they recover further from a tough 2020.”