stocks to buy: Growth vs value: Which stocks will outperform in a high inflationary environment?

The sky-high inflation is pinching the pockets of major economies. The inflation figures released this week in the United Kingdom, United States, and India have been consistently higher. Although measures have been taken to reduce inflation, uncertainty still lingers. It seems inflation will stay over the comfort levels of central bankers for a while. Investors often face this dilemma of investing during such high inflation.

I believe that value stocks will beat growth stocks. Before we dig in, let’s understand their dynamics.

A combination of 3 factors together leads to outperformance or underperformance.

Growth stocks, especially with high valuation multiples are vulnerable to high inflation rates. In order to curb inflation, the central bank raises interest rates which ultimately causes bond yields to rise. This doesn’t bode well for growth stocks.

Their projected earnings are dependent on the distant future and are discounted to net present value with the use of a discount rate (bond yields).

Rising interest rates imply a higher discount rate for growth stocks, which reduces their net present value of future cash flows. Therefore, the multiples tend to fall when the discount rate goes up.

Consequently, in the course of rate hikes, the P/E multiples are negatively tied to an increase in bond yields.

Value stocks work the other way around when bond yields climb north. Value stocks become attractive during such times since they trade much closer or in fact even lower than their intrinsic value. Value stocks also have a strong cash flow which makes them more attractive during such times unlike growth stocks.

We have observed throughout history that inflationary periods are positively correlated with value stocks outperformance.

The ratio between the Russell Growth Index and Russell Value Index shows the outperformance of growth stocks when the US 10-year bond yield was on a downward trajectory. However, it bottomed in July 2020. On the other hand, when yields began to rise, value stocks started to outperform.

From where we stand now, the fear of higher US inflation still looms.

Given the US Fed’s hawkish stance, some people are expecting even a 100 bps rate hike. As the 10-year bond yield continues to increase, value stocks are back in action. Due to their tendency for quick and sharp reversals, the early signs are already visible.

The Russell Growth Index has fallen ~25 per cent while Russell Value Index declined only 12% year-to-date.

Amid the turbulent times of inflation, one should remember the words of Albert Einstein who said, “In the middle of difficulty lies opportunity”.

Expectations of the Week

Early next week the FOMC and press conference will be the main headliner. Inflation in the US has already created carnage in the indices when the headline CPI and core inflation for August 2022 were above the street expectations. Markets around the globe are expected to dance to the tunes of the outcome of the Fed’s meeting. India though has performed relatively better than all the major markets, is anticipated to remain volatile. Nifty50 closed the week at 17,530.85.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)