Growth vs Value

An article by James Scott-Hopkins quoting thoughts from Terry Smith of Fundsmith on the trend for rotation of Growth stocks to Value.

There has been much talk over the last year of a rotation from Growth companies, those younger and perhaps more technology based that have the potential to outperform the wider market, to Value companies, probably more likely to be longer established ones whose value is trading below what others feel their stock is worth. The share price of Growth companies is based on their future earnings which is reduced in real terms if interest rates rise. Generally slower growing companies are less affected by this phenomenon hence the reason many have commentated on this rotation.

If interest rates are on the rise, should one not therefore be switching from Growth to Value stock?  According to Terry Smith of Fundsmith, the answer is, no. ”Owning high quality companies with sustainable growth is a winning strategy over the long term that has been shown to work through several economic cycles and is one which we know we can execute successfully. Whilst other managers may be able to run a value strategy, we believe it is inherently more difficult as you cannot hold value companies for the long term if all you are doing is owning a poor-quality company at a low price which you hope will re‐rate in the future. If this does happen you then must sell the company to find another such investment, and so on.  This means time is not your friend, because the longer you are holding the company and waiting for it to re‐rate, the lower your annualised returns become and if you’re particularly unlucky, the worse the company becomes.”

On the other hand, it matters less if it takes more time for the market to appreciate the value of Growth companies because the highest quality companies tend to get better, or at the very least bigger owing to their growth. “Imagine a dog walker crossing a field, their dog wildly zigzagging around them. We would relate the companies we own to the walker, clear in direction and making steady progress across the field, while the daily market price is like the dog, moving back and forth quite randomly. Now, the current economic storm may well send the dog cowering for cover, but given enough time, we know that the price and value will eventually meet again, just as the dog and walker will ultimately leave the field together. We are also confident that, as well as making constant progress, a high-quality company, if it trips during the storm, will rise again and keep going. Low quality, value companies on the other hand, may never get back up.”

The current volatility we are seeing now is because of the uncertainty in how aggressive Central Banks will be in raising rates to curb inflation.  But raising rates too quickly and too far creates its own problems and could tip world economies into recession. It is something the authorities will be keen to avoid.  Further inflation is likely to drift down on its own accord.  Ironically energy prices are deflationary overall as they directly affect the pocket of the consumer reducing economic activity and dampening inflation. We might well see fewer rate rises than the Press are anticipating. In any case moderate inflation is unlikely to harm companies with low raw material costs and high margins the type that Terry Smith includes in his funds.

Terry Smith manages both the Fundsmith Equity fund and Smithson Investment trust, both of which feature in the Irongate bespoke portfolios.

Terry Smith manages both the Fundsmith Equity fund and Smithson Investment trust, both of which feature in the Irongate Bespoke Portfolios.

An article by James Scott-Hopkins, Managing Director, Irongate

The value of an investment can go down as well as up.

You may get back less than you invested.

Past performance is not a reliable guide to future performance.

The opinions expressed are those of Irongate, this material is not a recommendation, or intended to be relied upon as a forecast.‍‍