As inflation and interest rates rise around the world, investors are being encouraged to consider a rotation of investing styles from growth stocks to value.

During times of rising interest rates, professional and sophisticated investors have traditionally shifted from a focus on stocks that were expected to grow strongly to those that were under-priced and offered value.

In the view of James Holt, Perpetual Investment’s Director of Investment Solutions, rising interest rates and bond yields will extend the correction underway in growth stocks, challenging investors with large exposures to big tech and other companies with high price-to-earnings ratios that dominated the investment landscape for the past five years.

Hidden value behind the market noise

Those same conditions, however, act as a tailwind for stocks that trade at lower valuations, because they do not share the same extent of downside risk but can also grow earnings due to factors such as rising commodity prices, pricing power, stronger balance sheets and may even business models that have the ability to gain from higher rates.

“Historically, regime changes between value and growth occur after recessions and/or major market crashes.”

Source: Strategas Research Partners.

“There are hidden value investment gems among the market noise of COVID, market falls, rising inflation and interest rates, Russia, China, war and more.”

Lessons in long term inflation

These are unfamiliar conditions for many market participants whose investment habits have been conditioned by plentiful liquidity, low interest rates and low inflation for a long time. Until early this year, equity markets were resilient in the face of the rate hikes, but they are now coming around to a view in the bond markets that tighter monetary policy to tame inflation will be here longer.

Historically, when the bond market and equity market disagreed, the bond market was usually correct, notes Holt.

Investors were served a powerful demonstration of this track record in late August when US Federal Reserve chairman, Jerome Powell, shot down an overly optimistic equity market view that central banks would be forced to reverse course on hiking interest rates early to avoid recession in the US.

Powell’s comments highlighted that the fight against inflation and inflationary expectations may take a longer time, jolting share markets and supporting the rotation to value stocks.

Holt says central banks still have a long way to go to normalise rates. The Reserve Bank of Australia has pushed rates to 2.35% in early September and have canvassed the impact of going above 3% while markets are pricing in a likely rate of 4%, and the US heading towards a likely 3.7%, the highest rates seen in 15 years.

“The fight against inflation is not over.”

Identifying value stocks and what drives them

Value stocks tend to perform during recoveries and through the middle of the economic expansion, while growth outperforms later in the cycle.

Value stocks dominate in Australia via banks and resources, although they also outnumber growth stocks in the global industry classification standards (GICS) system used to construct indices such as the MSCI index. Holt notes that there are variations such as “cyclical” value sectors, including financials, energy, materials and industrials and “defensive” value sectors such as utilities, healthcare, telecommunications, consumer staples and real estate.

Holt says the conditions will favour companies who have pricing power or products in hot demand and short supply, as they can pass rising costs on to their customers. Inflation will lift sales revenue, while margins can be maintained or even expanded by rising prices. The sectors best placed for this include in-demand commodities ranging from oil and gas to iron ore and so-called ‘green metals’ that are needed for the electrification of the economy.

Pricing power and power pricing

Holt’s favoured stock is Santos (ASX: STO), as an asset rich energy company with a focus on gas, which will be the preferred ‘transitional’ energy as the economy moves from a reliance on coal-fired power to more renewable energy and batteries.

In contrast, companies that are unable to pass on rising costs such as input materials or higher wages, will see margins and profits squeezed.

Meantime, Holt says insurers such as Insurance Australia Group (ASX:IAG) have been hurt by expectations of the rising claims cost from flooding and other disasters in Australia. This is also leading to increased premiums but rising interest rates help their fixed income-dominated investment portfolio and any decline in claims as weather normalises will further drive a profit recovery.

Higher rates less valuable for some

The picture is more mixed for defensive value sectors such as real estate investment trusts and utilities. Both sectors can be attractive at a time of rising inflation and interest rates from the delivery of regular income from long-lived real assets. If, however, they carry large debt loads, as is often the case, higher rates can raise interest costs and crimp returns, Holt warns.

The healthcare sector is challenging; on the one hand the vast majority of an individual’s healthcare spending comes after retirement. The baby boomer generation, the biggest and wealthiest cohort of developed economies and leading beneficiary of the past 30 years of falling interest rates, is now retiring and will underpin rising revenue for healthcare businesses.

Globally, many healthcare names are undervalued but in Australia, CSL dominates the sector. Whilst it is a high-quality company, it is also very expensive, complicating the ability of value investors to get exposure here.

Rotation just getting started

Holt notes that previous rotations into growth had generally lasted three to five years. But the recent ascendancy of growth stocks since the global financial crisis, had been extended by ultra-low interest rates and the massive stimulus payments to help business and households through the COVID-19 lockdowns.

“Globally, the rotation in investor focus from growth to value stocks has only just begun and is expected to gather steam with growth stocks continuing to deflate,” Holt says.

“In Australia, we are possibly close to half-way through the rotation.”

Source: Goldman Sachs Global Investment Research

He notes deep value strategies will tend to have portfolios that are dominated by cyclical companies and that they tend to do well in a ‘risk-on’ environment, where market expectations are for strong economic growth in certain sectors that are muted by fears over economic stress.

Defensive value portfolios tend to be dominated by companies with stable or compounding earnings and tend to do well in a risk-off environment where markets are concerned over slowing economic growth or recession.