Are you at risk of missing the 'recovery moment' in ASX shares?

Inflation is making the investment environment uncertain, but that doesn't mean investors shouldn't be invested.

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Key points

  • Value shares have been outperforming growth shares in 2022
  • Some analysts think this is going to continue, with growth shares to keep hurting
  • However, fund manager Pengana thinks some investors risk missing out on some returns

The ASX share market has seen plenty of volatility since the start of 2022. The S&P/ASX 200 Index (ASX: XJO) is down, but not by a lot – it's in the red by around 14% this year.

But, there are some individual names that are down a lot more. For example, the Xero Limited (ASX: XRO) share price is down around 50%, the Wesfarmers Ltd (ASX: WES) share price is down more than 25%, the Magellan Financial Group Ltd (ASX: MFG) share price is down around 40% and so on.

So, what's an investor supposed to do? Does it make more sense to buy ASX growth shares after their steep fall, or should ASX value shares be the way to go?

Funds management business Pengana Capital Group Ltd (ASX: PCG) has outlined some thoughts about the situation.

What is a value share?

According to Pengana, 'value stocks' are ones that have share prices trading at a lower multiple to the balance sheet or profit than the wider market. The fund manager named some sectors that have businesses that are regularly called value shares, such as banks, supermarkets and utilities that deliver "more dependable, immediate profits".

The types of businesses that can generate consistent and reliable profit in this inflation environment may be attractive to some investors. The fund manager said inflation increases business uncertainty. Businesses with more predictable earnings streams become "relatively more attractive", which supports value shares.

Pengana noted that after a decade of underperformance, (ASX) value shares saw a strong recovery in performance.

Should investors go for ASX value shares or growth shares?

Pengana said:

Investment textbooks tell us that value stocks generally outperform growth stocks in periods of rising interest rates and economic slowdowns. However, history tells us that investors who wait for certainty that the market has pivoted from favouring value back to growth are likely to miss the mark.

The tricky thing is that market lows and interest rate peaks can only be confirmed in hindsight. The fund manager notes that recent share market history offers little support for the strategy of 'waiting until the maximum market drawdown has passed' before investing in growth companies.

As I've already mentioned, many ASX growth shares have already been smashed in 2022 as multiple factors punish their valuations.

Pengana pointed to a couple of reasons why growth shares are hurting so much.

First, higher variable debt costs are reducing company profits, especially hurting those with already-thin profit margins.

Second, "higher bond yields increase a company's equity discount rate which reduces the present value of future earnings and thus its market value. This particularly impacts growth companies whose profits lie further out into the future".

Pengana has noted that some analysts are tipping that value shares can continue to outperform growth shares as higher interest rates slow the economy. Those value-focused analysts think that investors would do well to favour a value strategy until the market starts to show signs of recovery, and only then should a portfolio be rebalanced towards growth stocks.

But that's not Pengana's view.

How the fund manager sees the picture for growth shares

Pengana said:

This 'recovery moment' may arrive some time before the interest rate cycle peaks, because share markets are forward indicators of future economic health. Markets look ahead towards the economic recovery which follows the eventual downward turn in the interest rate cycle.

Moreover, the suggestion that growth stocks only begin outperforming value sometime after the maximum drawdown is not supported by historic data.

Investing in high quality growth companies, with moderate debt levels, has served as a good investment strategy for investors willing to ignore shorter-term market fluctuations. Such a strategy requires investing for the long term and recognising that well managed companies that grow earnings over time can sometimes be poor short-term performers.

It will be interesting how things play out for ASX growth shares from here and whether Pengana is right.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Xero. The Motley Fool Australia has positions in and has recommended Wesfarmers Limited and Xero. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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