Over the past few months, there has been a great deal of talk about ‘rotation’ within the stock market. Much of the commentary on the topic focuses on growth versus value investing. However, it may be helpful to supplement the discussion by considering cyclical versus secular investment themes.
A few basic definitions are helpful here: ‘Value’ stocks are bought because they appear to be inexpensive; ‘Growth’ stocks, as the name suggests, are attractive for their growth potential; ‘Cyclical’ stocks are those whose performance is generally tied to economic conditions; ‘Secular’ stocks are appealing due to non-cyclical, longer-term trends. While they are related, growth/value and cyclical/secular are two different lenses for analyzing market movements.
From the onset of the COVID pandemic and through the summer, value/cyclical stocks – which are more reliant upon consumer and business spending – performed extremely poorly. Growth-oriented, ‘stay-at-home’ stocks outperformed due to their defensive characteristics.
This started to change in September when markets began to price in the likelihood of a ‘blue wave’ election result. Presumably, a unified Democratic government would have provided a huge stimulus plan including expansive infrastructure spending. The market assumed that this would help beaten down value/cyclical segments of the market, and so these stocks began to strengthen.
The blue wave didn’t materialize but the market did not revert back towards growth stocks for long because, on November 9th, there was extremely positive news relating to COVID vaccine trials. This provided the ‘light at the end of the tunnel’ the market wanted, and cyclical/value stocks rallied.
Since then, the rotation has continued in fits and starts. For the year through the end of November, the S&P 500 Growth Index has outperformed the S&P 500 Value Index by around 30%, so there is still a great deal of potential for mean reversion.
Produced by Andrew Greenberg using information provided by Morningstar.
The obvious question is Will the rebound in value stocks continue? Since our crystal ball is broken, we focus on a question that is easier to answer: Which value stocks will likely be the best investments?
When thinking about this, it may be worth considering cyclical versus secular trends. Traditional value investing often results in buying into cyclical economic sectors. Unfortunately, due to the COVID crisis, many business models are changing, and certain secular challenges may be insurmountable. This leads to one of the dangers of value investing: the possibility of falling for ‘value traps’, companies that are permanently cheap due to long-term headwinds. The potential for value traps makes indiscriminate value investing somewhat perilous, especially at the current time. Considering secular trends when evaluating the value space can help distinguish between stronger and weaker investment prospects.
For example, developments in e-commerce and remote working have been magnified by the pandemic. The implications for sectors like retail and commercial real estate (among others) are enormous. As vaccines begin to be produced and distributed, there will likely be other long-term changes to business and consumer behavior. Additionally, the incoming Biden administration may influence the adoption of secular trends (a likely focus on climate change comes to mind). These concerns should be considered as part of the investment process.
So where does this leave investors considering a shift toward value? Two possible approaches may be helpful:
First, employing a ‘quality’ screen on top of value criteria can help identify stronger companies that are less exposed to secular issues. Quality businesses have higher, more consistent profitability and more robust balance sheets. Accordingly, they are generally better positioned to make it through the COVID landscape. Conversely, value stocks with weaker quality metrics are more likely to be shakier cyclical companies or value traps.
Second, consider sector/industry investing. Many of today’s secular challenges are industry wide. Rather than trying to avoid a single weak company, investors can invest in traditional value sectors (and avoid others) based on the long-term prognosis for those groups. For example, energy has been punished this year due to the extreme reduction in travel but surged in November. From a secular perspective, does owning this sector make sense? (1) On a long-term basis, there will likely be less business travel due to the adoption of virtual communication platforms; (2) Long-term supply is abundant as a result of technologies that allow more oil and gas to be taken from the ground; (3) Movement toward sustainable energy sourcing has been steadily gaining in popularity. This is, of course, a cursory and incomplete analysis but it makes the point that the energy industry faces significant secular headwinds.
Ultimately, investors considering shifts within their stock portfolio should look past the simple ‘value versus growth’ conversation. Considering long-term secular trends in the analysis may lead to more informed decisions and provide more actionable investment ideas.
All information herein has been prepared solely for informational purposes, and it is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy. There are no guarantees any investment or strategy will meet its intended objective.