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Causeway Capital Commentary: Rationalizing the Irrational

Will the earnings of value stocks decline forever? Current market multiples for the MSCI Value indices appear extremely pessimistic, suggesting negative perpetuity growth for value stocks across all global geographies, even as the world economy is forecast to grow. It may surprise our readers that, since the market trough in 2009, value stocks have beaten growth stocks at their own game, having exhibited greater earnings growth. As the gap in implied earnings growth between value and growth stocks reaches new highs, we find the current value recession increasingly irrational.

It is no secret that value stocks have underperformed growth stocks in recent years, but under the surface there has been a more pervasive trend at work. The market has gradually determined that the earnings of value stocks are worth far less than those of growth stocks. This is reflected in their relative multiples. Exhibit 1 plots the difference in the next twelve months' price-to-earnings (NTM P/E) multiples between regional MSCI Growth and Value indices since December 2008, in the midst of the global financial crisis (GFC). Across all geographies, the gap has marched steadily wider over the last decade. And in the first half of 2019, we witnessed the spread increase sharply. As of June 30, 2019, the noted Growth indices traded at a 7-9x P/E premium to the Value indices.

Growth stocks have steadily re-rated upward across geographies since the GFC.

Exhibit 1. NTM P/E of each respective MSCI Growth Index minus that of the corresponding Value Index

What has caused such a divergence in appetite for these two styles? There are many potential explanations, but the reasons do not appear to be related to underlying earnings growth itself. Most investors naturally assume that "growth" stocks demonstrate greater earnings growth than "value" stocks, but that has not occurred, at least in aggregate, during the post-GFC bull market. Exhibit 2 compares the total percentage change in P/E multiples with the total percentage change in NTM earnings per share (EPS) estimates for the Value and Growth indices across geographies. The left side of the chart shows that, as we saw in Exhibit 1, P/E multiples for Growth indices have grown much more than Value multiples in the period since the GFC market trough (in March 2009). More surprising is what we find on the right side of the chart examining relative growth in EPS. Outside of the United States, value-stock earnings have ironically grown more than growth-stock earnings over the same time period. Even in the United States, value stocks have kept up with the earnings growth exhibited by growth stocks and yet have witnessed only one-fifth of the upward "re-rating" of US growth stocks (16% vs. 80%).

Value earnings have largely outgrown growth earnings despite relative de-rating.

Exhibit 2. NTM P/E multiple growth vs. NTM EPS estimate growth since GFC trough for Value and Growth indices

Recent growth outperformance is therefore not attributable to superior earnings growth, but solely to the market's revaluation of those earnings. So what else might have caused this change in preference for growth stocks? Interest rates have undoubtedly played some role. Decreasing the discount rate applied to cash flows will necessarily increase their present value. Since growth stocks tend to have more of their cash flows expected in years far in the future (i.e., longer duration), lower interest rates should have a more positive impact on the present value of growth stocks relative to value stocks. Exhibit 3 charts the falling average 10-year yields in each geography. We use the Emerging Market Bond Index (EMBI) spread to US Treasuries as a proxy for average emerging markets sovereign rates.

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This article first appeared on GuruFocus.