Rethinking Growth in a Broadening Economy

The Growth-Value Paradox

Conventional factor analysis of the underlying performance consistently flags that both quality and growth have continued to underperform value. And it seems paradoxical to suggest that broadening and strengthening economic growth results in relative underperformance of growth as a factor.

However, this contradiction melts away on closer inspection. The MSCI Value Index[1] assesses a security’s price-to-book ratio, forward price-to-earnings ratio, and dividend yield to evaluate its inclusion in the index. Not surprisingly, financials stocks account for nearly a third of the value index by weight.

For much of the 2010s, global growth was anemic, interest rates were low, and real rates were outright negative in many places. Financials companies, which rely on the interest-rate spread, economic activity, and credit growth, delivered uninspiring returns and were shunned by investors. They became inexpensive, with no improvement optionality priced in.

Over the past several years, economic growth has broadened and the growth wedge between the United States and other major economies began to shrink, as we discussed in last quarter’s outlook, “Policy Reactions Narrow Global Growth Gaps.”

In addition, interest rates have risen across developed markets on the back of COVID-related inflationary supply disruptions; there is also a focus on growth in Europe and Japan, and banking stocks from these jurisdictions have delivered significant returns for investors.

In other words, improvement in economic growth has translated into earnings improvement for many companies in the MSCI Value Index.

More broadly, a key pillar of Japan’s corporate governance reform effort is to “name and shame” companies whose market value is below book value.

Specifically, since January 2024, the Tokyo Stock Exchange has published a monthly list of companies that have disclosed information regarding their capital efficiency initiatives to help improve overall capital allocation and raise return on equity for Japanese companies. As more and more companies succeed in improving their capital allocation and migrating to higher-growth end-markets, they offer rich investment opportunities for the skilled investor. And they are largely in the value indices.

Just as growth remains highly dynamic, so are the indices. When examining the composition of the broad indices, whether MSCI for global markets or Russell for the United States, we found that the constituents of the growth and value indices change regularly. In the past two decades, we have seen that 75% of the constituents have changed back and forth between growth and value, giving little merit to paying attention to the index when searching for where growth is inflecting.

Seeking Pockets of New Growth

As quality growth investors, we continue to look for growth and where it is changing, and we continue to find much to be excited about.

We have written extensively about European and broader defense, and it continues to be a rich growth area, as discussed in “Mapping the Future of EU Defense Spending.” While Russia’s invasion of Ukraine in early 2022 catalyzed the performance of defense stocks, the sector wide re-rating has likely played out. Now, it is up to those companies with earnings power that can deliver.

Defense remains at the technological frontier, and today, it means remotely operated equipment such as drones, which rely on ubiquitous and secure connectivity. Needs drive innovation, and we see tremendous activity in the buildout of low(er)-Earth-orbit satellite constellations that can provide low-latency connectivity over transregional and transcontinental distances.

For now, defense companies are building out the infrastructure—such as reusable rockets and engines—and satellite constellations necessary to deliver on this vision in the next handful of years. Over time, ubiquitous connectivity and surveillance will, for example, likely enable entirely new businesses in autonomous transport, banking, and healthcare delivery.

In addition, the AI buildout continues to pressure power generation demand in markets where electricity demand has not accelerated in years. Consequently, there are ample growth opportunities for power providers, utilities, and all those industrials that are involved in producing power, converting it into electricity, and delivering it securely to the end-consumer.

As ever, improving growth translates into stronger earnings streams, which at times are underappreciated. Asset price appreciation is the result, whether a company is classified in a value or growth index. This constant quest for improvement is at the core of what we do.

Hugo Scott‐Gall, partner, is the head of William Blair’s global equity team, on which he also serves as a portfolio manager.

¹ The MSCI Value Index is a stock market index that represents the “value” segment of a broader MSCI equity index such as the MSCI World Index, MSCI USA Index, MSCI Europe Index, or MSCI EM index.

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