Go for Quality

Today's trading showed a clear split between value and growth stocks, with the former outperforming the latter by a full percentage point. Since the start of 2020, however, growth stocks have trounced value: The Vanguard S&P 500 Growth exchange-traded fund  is up 70%, versus a 22% return including dividends for the Vanguard S&P 500 Value ETF.

Value stocks are generally defined as those that trade at a discount to the market on a variety of valuation metrics, while growth stocks are those that are expected to increase their revenue or earnings faster than the market average. But that distinction isn't likely to be as meaningful for returns going forward as it has been so far during the Covid-19 pandemic.

Barron's Jacob Sonenshine explains:

What’s the outlook for value and growth? On the one hand, real gross-domestic-product growth is expected to slow down in 2022 from 2021, according to FactSet. That doesn’t do any favors for value stocks.

On the other hand, prices of many value stocks are already reflecting slower growth, making those shares relatively attractive. The aggregate forward price/earnings multiple for S&P 500 value stocks is currently about 12 points lower than the index’s growth multiple, whereas the difference has averaged closer to 5 points in the past 10 years, according to Credit Suisse data. So the prices of value stocks aren’t necessarily reflecting their expected earnings growth as much as those of growth stocks.

Typically more economically sensitive value stocks could be a tough bet in a slowing GDP-growth environment. Growth stocks, meanwhile, are particularly pricey and sensitive to higher interest rates, which bring down the present value of their future earnings. 

In other words, investing based on growth or value factors alone isn't likely to be a recipe for outperformance in 2022. Instead, Jacob suggests that investors focus on the companies that can exhibit the best of both worlds.

Quality companies with low debt, stable earnings, and higher-than-average returns on equity should be able to navigate a slowing growth and higher interest rate environment. They can control their own fates and withstand the impact of Federal Reserve rate increases. The iShares MSCI USA Quality Factor ETF (QUAL) is an easy way to bet on that group.

Read more from Jacob here.