Growth and Value aren’t enough

Growth and Value aren’t the only options. Quality can help position portfolios for the economic cycle.

With hundreds of billions invested in Value and Growth strategies, the popularity of these investment tilts is undeniable.  And for good reason!  Value and Growth strategies tend to exhibit negative correlation of excess returns[1], meaning that when they are combined in a portfolio, they can deliver diversification benefits.  Plus, by holding positions in both strategies, investors have the tools to express their views on the market, tilting more towards growth or value in certain market regimes.  So, as Growth strategies begin to look rich versus historical fundamentals, many clients are asking if it is time to take some Growth chips off the table and tilt toward Value.

Value and Growth: Get your risk on

The issue with the binary choice between Value and Growth is that in the most general sense, both are foundationally risk-on approaches.

It is no secret that the Value factor typically does well post-recession when the economy is recovering, while Growth tends to perform well during the expansion phase.  However, should the economy as well as investment styles really be defined as binary? Or should investors consider investment styles beyond Value and Growth to express views in market environments beyond just recoveries and expansions?

BlackRock believes that the market experiences a gradient of cycles, extending beyond recoveries and expansions to include slowdowns and contractions. In a similar manner, we believe investors should consider a gradient of factors in portfolio construction beyond simply Value and Growth as broad categories. As my colleague Andrew Ang has written, the Growth category generally represents some stocks which are priced more expensively for good reason, and some which are not.  We can benefit by focusing on those aspects of growth which have been historically most rewarded: namely stocks with strong balance sheets and a robust trend. By getting specific about what we mean by Growth, investors can focus on the aspects of growth that are most attractive in today’s market environment.

With these considerations in mind, I believe clients are asking the wrong question when they weigh if it is time to sell traditional growth and rotate into value.  Rather, in an environment where many Growth-oriented stocks may be priced to perfection, and clients are looking to make portfolio changes, is Value necessarily the right place to turn?  If your projections support an environment of economic recovery, then the answer might well be yes. If however, you believe markets are heading toward a slowdown or contraction, Value may not be the most timely investment strategy to deploy.  In this latter case, seeking more resilience may be warranted. Quality investments can offer a protective middle ground between the typical Value and Growth dynamic. Quality companies generally exhibit more profitability, less leverage and stable earnings relative to their peers, making them more resilient when earnings may have peaked or an economic cycle is maturing.

Below we see the typical behavior of a global business cycle.

value and growthFinal

Value, Growth and Quality is a long-term proposition

For investors looking to make a change in reaction to deteriorating market and economic dynamics, Quality may offer an opportunity to build more resilience into portfolios. However, while we believe altering portfolio allocations around the economic cycle can add value, timing the market is difficult even for the most experienced investor.  As such, Quality, like other factors including growth-oriented Momentum and Value, can play an important role in investors’ portfolios throughout the full business cycle, delivering exposure to diversified sources of rewarded returns.

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Conclusion: Growth and Value aren’t enough

When growth-oriented names appear stretched, but tilting toward Value in a volatile economic slowdown doesn’t feel quite right, where do you go? Quality companies have typically answered this question, providing a defensive equity exposure by emphasizing stocks with strong balance sheets and stable earnings.

We believe incorporating Quality can help add a new, protective dimension to existing style box portfolios. Both over the full business cycle and during economic periods of slowdown and contraction, we believe Quality captures an important source of diversified and rewarded return. Thus, regardless of your investment framework, the addition of Quality can bring resilience to investment portfolios, turning a 2-dimensional decision into something more diversified and robust.

Holly Framsted, CFA, Director, is the US Head of Factor ETFs and is a regular contributor to The Blog.

[1] MSCI USA Value and MSCI USA Growth Indexes vs MSCI USA over the last 10 years as of 10/31/2018.

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