Do value shares perform better than growth shares when inflation levels are high?

Aug 3, 2020

Welcome to Finance and Fury.

This episode – want to continue looking at theory versus reality – Focus on the theory of Value versus Growth investing in an inflationary world – and which one does better

1. Looked at if inflation will return – but if it does - maybe Value shares start to outperform growth shares again

Inflation is a major focus in the current economic world – especially since the 90s –

1. Everyone pays attention to it - Investors, businesses and especially Central banks - continuously monitor and worry about the level of inflation
   1. Some just have to worry about it – whilst one tries to control it through interest rate policy
   2. Inflation—the rise in the price of goods and services—reduces the purchasing power each unit of currency can buy. 
   3. Rising inflation has an insidious effect: input prices are higher, consumers can purchase fewer goods, revenues, and profits decline, and the economy slows for a time until a measure of economic equilibrium is reached
      1. This occurs when there is inflation without the economy booming
   4. Don’t like to generalize about inflation's impact on equities and markets - different groups of stocks seem to perform differently
2. But Historically – some studies on data have shown in general - Value stocks perform better in high inflation periods and growth stocks perform better during low inflation – but these timeframes were over a decade period
   1. However - When inflation is on the upswing, income-oriented or high-dividend-paying stock prices generally decline – which seems counter intuitive – as these types of companies are a core component of value investing portfolios
   2. Overall – shares – both growth and value types do seem to be more volatile during highly inflationary periods.
3. Investing for me is a long-term strategy – have to try and look at long term
   1. You have to be thinking into possibilities for the future – have to potentially plan for higher inflation at some point but there are likely some areas of the market that would benefit more from an inflationary spike than others.
   2. In a low rate, low inflation world, growth stocks tend to perform better while value stocks tend to do better when inflation is higher – what has been seen over the past decade or more now
4. However – what does the theory say
   1. The general theory goes along the lines of the following - The same thing is true of promised future growth in revenue or profits for growth stocks. Value stocks likely already have cash flows now that will likely decrease into the future. Thus, higher interest rates should hurt value stocks less than growth stocks since the higher hurdle rate makes future growth not worth as much.
   2. This theory is thinking about growth stocks like they are a bond but based around the assumption that the reason inflation is such a big risk for bondholders is because the purchasing power of your fixed rate income payments is eroded over time by inflation.
   3. However – I think that there is a different explanation to this – interest rates and debt financing costs
      1. More so that the bond is worth less in real terms when it matures than the ongoing income –
      2. If there is inflation then the company should be able to sell its good at a greater rate –
   4. Original theory - The original Fama-French paper covered a period of very high inflation, the years 1963-1990, and consequently showed a robust value effect
      1. Fama and French were professors at the University of Chicago Booth School of Business – lots of works
      2. Towards the start of the 90s, interest rates and inflation commenced a long and powerful decline - continues to this day—just the sort of environment expected to favour growth stocks
   5. Back with the gold standard and there is zero inflation - growth and value stocks have equal returns
   6. Looking at the data – have a measurement of High Minus Low (HML) is a value premium - value stocks over growth stocks
      4. From back in the 30s – I/O - -2% and -4.5%
      5. 40s: 5% and 10%, 50s and 60s: 2% and 4%
      6. 70s – 7% and 10%, 80s: 5% and 6%, 90s and 2000 – 2.5% and 4-6%, 2010s – 2% and -4%
      7. Mapping this out - the slope of HmL on inflation is 1.1, so each one percent of inflation adds about one percent of HmL. Thus, if inflation stays at 2% to 3%, we can expect an HmL [value premium] of similar size. And not coincidentally, the HmL for the full 74 years from July 1926 to June 2000 was 3.36%, while inflation was 3.12%
         1. But the most recent decades have been mixed – since the 90s – with inflation same rate as the 50s and 60s – underperformed by 10% -
      8. Looking at how this works - the data that the HmL uses is dependent on the absolute level of inflation – not its rate of change
         1. in an efficient market – should a high (or low) rate of inflation produce high (or low) HmL?
         2. Based around the theory – it can be assumed that a static high or low inflation rate would be discounted into prices

• Going back to the theory – at the heart of the value premium – if markets were efficient and always followed theory - any premium can only be compensation for some sort of risk

1. But as we know - markets are not always efficient - investors overestimate earnings increases for growth stocks and do over price them and can under-price value shares

1. You can see from the chart that the middle ground of 2-4% inflation has lead to mixed results in the value vs. growth leadership so this relationship isn’t foolproof. But inflation isn’t the only factor necessary for value to outperform
2. The theory of this - As long as there is fiat currency, it is expected that there will be inflation; in the long-run, the value premium seems assured – so there should be out performance of value shares with inflation

 

These theories aren’t all-encompassing to explain what’s going on in the markets because you can never narrow these things down to a single variable - There are simply too many moving parts when it comes to reasons markets do what they do.

But I find it helpful to keep an open mind when it comes to market moves that sometimes make no sense. Markets don’t always have to make sense

 

And when looking at smaller or different timeframes – is there more to the story

Based around some of the data backing this – so you might think that at higher or lower levels of inflation can mean that value investing underperforms growth investing in periods of low/negative inflation and that value outperforms in periods of high inflation – just not between the 2-4% band

1. Looking at cycles of value vs. growth outperformance - is it inflation that causes this or something else...?
2. Going back to the data first - limited number of data points when using the decade-long timeframes that have been used -
   1. Also the context of “normal inflation” between 2% and 4 has been a wide range of outcomes with regard to value vs. growth investments
3. But looking at shorter periods of time – have many more data points
   1. So this brings up a question of does the relationship between inflation and value investing change as the time horizon grows from a short period (1 year) to a long period (10 years)?
   2. From these results - there is no relationship between inflation and value outperformance at the 1 year timeframe – then there is a relationship that has a correlation of 0.7 – a number that is considered a moderate but not strong correlation
   3. can you use the correlation that emerges over longer time horizons to make good investment decisions?
   4. So - if inflation is high (low) for some reasonable period of time, can we use that information to say that it is likely to be a good (bad) time to invest in value stocks going forward?
   5. Looking at the lagged correlation between inflation and value for increasing time horizons – see a different picture
      1. Some people have done more studies on this - split the last 90 years into sequential two-year periods - for 4-, 6-, 8-, and 10-year periods- then calculate the correlation between the inflation in the first half of each period and value’s performance in the second half of each period.
      2. when we look at the data in this way, there is no correlation between current period inflation and how value performs in the subsequent period
   6. Another time period – taking this with a the lagged relationship for nine 10-year periods from 1926 to 2015 – similar result
4. My View - the primary driver of why value investing works over some time periods and not others is not the level inflation -  markets are made up of investors – which are human -people search for a signal in the noise that surrounds the stock market
   1. Mistakes can be made – such as attribute too much meaning and overreact to information that proves to have little to do with the long-term value of their investments
   2. I like value investing – paying decent to undervalued prices for a good company – but in times where fundamentals matter little and there is a frenzy of purchasing shares regardless of prices – value can underperform – as was seen in the 90s before the dotcom bubble burst – or in the 2000s before the crash of 2008/2009
   3. Markets do always have responses to external developments - causes prices to fluctuate widely around companies’ fundamental values and presents opportunities to buy good companies at favourable prices
   4. But over the past 30 years - investors can become both excessively optimistic and pessimistic at similar levels of inflation due to external factors at play
   5. These theories aren’t all-encompassing to explain what’s going on in the markets because you can never narrow these things down to a single variable - There are simply too many moving parts when it comes to reasons markets do what they do - Good to have both growth and value – diversification

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