Bill Gross is back (kind of) and he has something to say on the growth versus value debate.
The veteran investor, who retired from fund management in March last year, has published his first investment outlook since 2019, in which he argues that the meteoric rise of growth stocks performance is more tied to real interest rate moves than value stock performance. And so, if real rates move higher, as he thinks they will, value will be poised to outpace growth again.
Never shy about commenting on stocks, even during his days as the manager of Pimco Total Return when it was the largest bond fund on the planet, Gross argues Treasury Inflation-Protected Securities (TIPS) yields are going higher, and that means value stocks are set to outpace their growth counterparts.
To make his argument, Gross dusts off the Gordon Growth Model, or the dividend discount model, a classic stock valuation tool that uses a simple fraction -- the dividend or cash flow a stock will produce for owners divided by a discount rate adjusted for a growth rate of the dividend or cash flow:
Price or Fair Value = dividend or cash flow / (discount rate – growth rate)
The smaller the denominator is – either from a decreasing discount rate, an increasing growth rate, or both – the higher the present value or fair value of the stock.
Gross argues that low interest rates for the past decade have goosed growth stocks in particular. A decreasing real interest rate combined with a steady growth rate ‘skyrockets the price,’ writes Gross, who takes the discount rate to be the real interest rate of the 10-Year TIPS bond or the real long-term interest rate.
He goes on to show that growth stocks are more highly correlated to moves in TIPS than value stocks. He highlights that Microsoft has .854 r-squared correlation to TIPS over the past two years.
‘When TIP goes up, Microsoft goes up. When TIP goes down (real yields up), Microsoft goes down. (Not daily, but over a week or two weeks’ time),’ he writes.
Gross argues that real interest rates must ascend from their extreme current lows, and that that rise means a higher denominator in the Gordon Model, giving value stocks the opportunity to shine.
Other investors have observed that higher rates benefit value stocks too. The higher growth that usually goes with higher rates often means there is more demand for commodities like oil, and energy is a large part of value indices. Higher rates and a positively sloping yield curve also benefit banks and financials, another large component of value indices.
The call for higher rates isn’t new for Gross. Although Pimco was famous for coining the phrase ‘new normal,’ forecasting tepid economic growth after the financial crisis, Gross struggled in his last years at Total Return with bets not always in accord with a low-growth, low-rate thesis.
Those struggles continued during his mostly unsuccessful run as manager of the Janus Henderson Global Unconstrained Bond fund (now called Janus Henderson Absolute Return Income Opportunities) where he bet against the German bund, arguing that it was ‘the short of a lifetime’ as he assumed its negative interest rate couldn’t persist.