Some Managers Already See Signs of a Growth Stock Comeback

It looks like growth managers may not have to wait until the end of the current economic cycle to take their revenge.

According to Los Angeles Capital Management, bearish sentiment toward growth stocks appears to be subsiding. The $37 billion quantitative investment firm found that the correlation between expected return and long-term growth exposure turned positive in March for the first time in months — meaning portfolios with a tilt to growth stocks should have higher returns. Value stocks, on the other hand, lost some of their appeal in March, after seeing a general increase in demand from investors last year. During the first quarter, the Morningstar U.S. Large Value index beat the U.S. Large Growth benchmark by more than 15 percentage points. 

“There has been a massive reversal in investor preference over just the last few weeks,” said Michael Schlachter, managing director and senior portfolio manager at LACM. 

Schlachter based his conclusion on findings from LACM’s own version of factor investing, which includes an analysis of investor demand. LACM has developed what it calls the “Investor Preference Theory,” which argues that a stock’s expected return is affected by “its risk characteristics and the price the market assigns to each characteristic.” Commonly known as factors, these risk characteristics include growth, value, momentum, quality, and many other features that LACM believes affect stock returns. But because price is determined by supply and demand, LACM also believes that by studying investor demand for specific factors, it can make better projections about which factors will outperform.

Schlachter told II that over the past two and a half weeks, LACM has observed a positive shift in investor preferences for volatility, leverage, and distress factors. The volatility factor, for example, saw its correlation with expected return bounce from negative 0.5 to negative 0.08, which signals that investors are becoming a lot less sensitive to volatile market conditions. This, in turn, suggests that market uncertainties about the Russia-Ukraine conflict and the macroeconomic environment are impacting investors to a lesser extent than they did a few months ago.

This is important, because increased tolerance for volatility usually signals that investors are ready to deploy more aggressive strategies, such as putting money to work in growth stocks. The fact that people are gravitating towards growth means they have become more risk-tolerant. “When you think about a growth stock, what it tends to have is a lot of potential cash flows in the future,” said Mike Hunstad, head of quantitative strategies at Northern Trust Asset Management. “Any time the markets get choppy, those cash flows come into question.” If people were still worried about the volatility brought on by geopolitical and macroeconomic risks as they were a few months ago, they would probably try to adopt a more defensive strategy, such as investing in value stocks. 

The current investor preference shift to growth means that investors’ “fears over global escalation of the Ukrainian conflict have eased,” Schlachter said. In terms of the macro outlook, he said that while yield curve inversions can signal rising recessionary risks, breakeven inflation rates continue to be steep, “suggesting investors remain optimistic that inflation will subside and real growth will be restored.” But he cautioned that because the inflection point occurred only recently, there is no guarantee that there will be a “full-blown growth wave.” 

Hunstad, on the other hand, believes that value stocks are better positioned than growth stocks under the current conditions. However, he added that while there is a common belief that value and growth stocks can’t outperform at the same time, that’s not always the case. “I think both [factors] have potential,” he said. “The tech sector doesn’t have to take a dive for value to outperform.”