With inflation on the rise should investors be buying value or growth?

Value investing requires patience and discipline - attributes that those who follow the strategy have needed in spades over the past decade.

It has been a tough period, with value underperforming growth most years since 2007, but in 2016 a reversal in fortunes started to play out, with the MSCI World Value Index returning 13.23%, ahead of the MSCI World Growth Index return of 3.21%.

As we have previously explained, the idea behind value investing is that a catalyst will occur to revive an underpriced company's financial fortunes, in the form of a restructuring, refinancing or management change that increases its earnings and dividends. In turn, this tends to lead value investors towards cyclical and more economically sensitive stocks.

There are various reasons why value investing is once again coming into favour, but one of the main catalysts has been shift in expectations towards better nominal growth, with the Donald Trump factor at play. The US president's pledges to cut taxes, while also increasing infrastructure and defence spending, has been keeping markets buoyant.

In this environment investors are more comfortable increasing risk and have therefore been taking a closer look at unloved businesses that fit the value description. But the big question from here is whether value investing's return to form will prove to be short-lived.

According to Kevin Murphy, a value investor and co-manager of various funds, including the Schroder Income and Schroder Recovery funds, there is a key reason why the value style tends to hold its own when inflation is on the rise.

As Murphy points out, inflation has not been much of an issue over the past couple of years; instead, deflation was viewed as more of a threat. "Usually, prices of goods and services head upwards over time (that is, they inflate), and so £1 buys you progressively less, the further out you look into the future," says Murphy.

"In times of deflation, however, prices of goods and services head downwards, and so your £1 buys you progressively more goods or services the further out you look. It is for this reason that growth businesses, or those with a long-term stable franchise, are prized significantly more highly than value ones in a deflationary environment.

"This is why growth businesses, and particularly high-quality companies with pricing power - the so-called 'bond proxies', such as food, beverage and tobacco groups - have been such great performers of late."

But with inflation on the rise, with most commentators expecting inflation to the end the year at around 2.5%, this trend could reverse.

"There are two broad styles of investing - value and what is often known as growth. A crucial difference between the two camps is the length of time before you might expect to make your money back - value investors do so more quickly by virtue of buying businesses in which the wider market has low expectations," adds Murphy.

"If inflation is making a comeback - and of course we are not offering a view on that, one way or the other - it would unwind a significant proportion of value's recent underperformance."

Murphy and his co-manager Nick Kirrage currently have Royal Bank of Scotland, Pearson and Aviva as the three biggest overweight positions in the Schroder Income fund.

'Why I am betting against quality growth names'

The downside to both growth and quality growth investment, however, is that investors risk buying at the wrong time and paying well over the odds. The trick is to try and buy shares that are priced below their intrinsic value, but this is much easier said than done.

At the current time this is particularly pertinent. The quality growth part of the UK market, particularly the consumer goods sector, home to the likes of Unilever and Diageo, has shone over the past six years or so.

However, some fund managers have moved out of the sector, including Richard Buxton, manager of the Old Mutual UK Alpha fund, who sold Unilever and Reed Elsevier in 2015.

"Over time I expect both bond yields and interest rates to rise, and in response markets will function in a much more conventional fashion, focusing on fundamentals such as valuations," said Buxton.

"Investors in this part of the market, such as Fundsmith's Terry Smith, will say these businesses are the survivors, and I have no issue with that - they are great businesses, and at some point there will be an opportunity to go back in.

"But I think there's going to be a reversal of the cash going into these quality names as we enter a more normal environment with a steeper yield curve."

Other fund managers have also moved to bet against certain quality growth names. James Clunie, manager of the Jupiter Absolute Return fund, has the freedom to "short stocks" - in other words make money when the share price falls.

Clunie is currently betting against 110 companies, 70 of which are listed on US stock exchanges. "Some are what I would call glamour stocks - people get very excited by how quickly these businesses are growing and overpay. Two stocks I am short are Tesla and Netflix.

"Then other stocks I am shorting are high-quality companies. When I have carried out analysis I have concluded that these stocks are simply trading at the wrong prices - investors are overpaying. One name I am shorting is Coca Cola."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.