Investing in US equities late in the cycle

Michael Bell, Global Market Strategist for J.P.Morgan Asset Management, explores how carefully selecting value stocks for a portfolio can be similar to managing a football team.

Investing in equities can be like managing a football team—you can’t just pick all the most up-and-coming, expensive players. It’s better to include some players who are perhaps past the peak of their international careers and hence a bit of a bargain, but are still likely to be solid and reliable members of the team for several years to come.

Carefully selected value stocks work for a portfolio in a similar way. Growth stocks, on the other hand, are the potential stars of the future. Like promising young footballers, they have a bit of work to do in the coming years and lots of room for development. They are more risky, though, because they could get injured before their large transfer fee pays off. But they also have the potential to take the team to the next level.

Managers will want a team with both types of player. But late in the game they might wish to switch towards the value players—those with a bit more experience—which can pay dividends when the pressure is on.

The basics

Several metrics are used to characterise a stock as value or growth, such as the price-to-book (P/B) ratio, 12-month forward price-to-earnings (P/E) ratio, dividend yield, and short and long-term earnings and sales growth. Value stocks—the steady players—have a lower P/B, a lower P/E and a higher dividend yield than the market average.

Growth indices are often highly skewed towards technology stocks. Information technology currently has a weight of 33% in the Russell 1000 Growth Index. It is no surprise that the growth style has performed particularly well when investors have been excited by the potential returns from rapid technological innovation, such as during the 1990s tech boom. By contrast, the Russell 1000 Growth Index underperformed through the stock market expansion of the 2000s, which was focused on housing, finance and commodities, rather than technological innovation.

The composition of the value index has changed more significantly through time. At present, the Russell 1000 Value Index is dominated by the financials sector, which makes up 22% of the index. Healthcare is the second-largest sector weighting in the value index, while consumer discretionary is the second-largest in the growth index, behind technology.

EXHIBIT 1: RUSSELL 1,000 VALUE AND GROWTH SECTOR WEIGHTS
% weight in index

Source: FactSet, Russell, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as of 31 March 2019.

When does growth tend to outperform?

In periods of rapid technological innovation or disruption, growth stocks will tend to tempt investors. Rapid technological change and cheap starting valuations for growth stocks after the financial crisis have proven particularly potent for growth stocks for much of the current market expansion.

EXHIBIT 2: RUSSELL 1000 GROWTH/VALUE RELATIVE PERFORMANCE AND S&P 500 DOWNTURNS
Relative index level, rebased to 100 in 1979

Source: Russell, Refinitiv Datastream, J.P. Morgan Asset Management. Index levels are calculated using price indices in USD. Past performance is not a reliable indicator of current and future results. Data as of 31 March 2019.

When does value tend to outperform?

Value stocks tend to outperform when the economy is in a more difficult phase (see also “How should we prepare portfolios for the next downturn”). This is because their lower valuation means they tend to fall by less than more expensive growth stocks during a bear market, and their higher income often offers a buffer for total returns. Value also often outperforms in the early stages of a recovery. This is in part due to the high weighting of financials in value indices. The early stage of the cycle normally benefits the financials sector because banks borrow at short-term interest rates and lend at longer-term interest rates, which means a steeper curve increases their future profitability. Value stocks significantly outperformed from 2000-2007, following the prior period of significant growth outperformance during the dot-com bubble of the late 1990s.

EXHIBIT 3: MSCI USA VALUE AND GROWTH PRICE-TO-EARNINGS RATIOS
x multiple, trailing 12 months’ price-to-earnings ratio

Source: MSCI, Refinitiv Datastream, J.P. Morgan Asset Management. Trailing P/E ratio is calculated using earnings per share for the last 12 months. Past performance is not a reliable indicator of current and future results. Data as of 31 March 2019.

Options for this stage of the game

Given the advanced nature of the cycle, and the relative pricing of growth and value stocks, investors may wish to consider adding a carefully selected group of value stocks to a portfolio. In previous downturns, and indeed during the correction in the fourth quarter of 2018, value stocks fell less than the overall market and outperformed growth stocks. The exception to this rule was the financial crisis, but a repeat of a financials-led downturn seems unlikely given banks are now more highly capitalised and capitalised and have less leverage than 10 years ago.

However, growth stocks are perhaps unlikely to underperform to the extent that we saw following the 1990s tech boom. In our view, structural tailwinds persist from the potential for further rapid technological advancement and disruption, while valuations for some growth stocks have come down significantly.

When it comes to size, in attack, the smaller, more agile, players are often the most skilful, and those you turn to when you need to build a lead. However, when defending a corner in the later stages of the game, you want your larger players on the field.

Likewise, while small cap stocks often perform well in rising markets, larger companies tend, on average to be more defensive and resilient during a downturn.

EXHIBIT 4: PERFORMANCE DURING S&P 500 DOWNTURNS SINCE 1990
% total return, USD

Source: Russell, Standard & Poor’s, Refinitiv Datastream, J.P. Morgan Asset Management. S&P 500 Quality index is the top 25% quality stocks in the S&P 500 determined by JPMAM Quantitative Beta Strategies based on measures of profitability, financial risk and earnings quality. Russell Value and Growth indices are selected based on three different factors. For Value, stocks are selected based on considerations of price-to-book ratio. For Growth, stocks are selected based on considerations of forecasted medium term growth and historical sales per share growth. All values are total return in local currency, unless currency is otherwise specified. Periods of downturn defined by the last three S&P 500 peaks to troughs in 1990, 2000 and 2007. Past performance is not a reliable indicator of current and future results. Data as of 31 March 2019.

As we near extra time in this expansion investors may wish to turn increasingly towards their more steady, resilient and experienced players, the large cap value stocks, to close out the game. At the same time, it’s important not to lose sight of the long term, and to keep a selection of growth players on the bench for the future.

But not all the more experienced, cheaper players are a bargain. Only the quality ones with lots of life left in them— those that are not struggling to compete with a younger star player in their position and aren’t worn down by past excesses from their partying days—will complement the team. Low quality stocks with high debt burdens or challenged business models tend to struggle during a downturn.

EXHIBIT 5: S&P 500 QUALITY/S&P 500 RELATIVE PERFORMANCE
Relative total return index level, rebased to 100 in 1990

Source: J.P. Morgan Asset Management Quantitative Beta Strategies, Standard and Poor’s, J.P. Morgan Asset Management. S&P 500 Quality index is the top quartile quality stocks in the S&P 500 determined by JPMAM Quantitative Beta Strategies based on measures of profitability, financial risk and earnings quality. Periods of “recession” are defined using US National Bureau of Economic Research (NBER) business cycle dates. Past performance is not a reliable indicator of current and future results. Data as of 31 March 2019.

A team consisting of only young, smaller, expensive players could struggle against a more balanced mix of youth and experience as the final whistle approaches. And given the more balanced team is less expensive, it seems like a less risky option at this stage in the cycle.


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