25 Feb 2021
The divergence between growth and value stocks was one of the chief market drivers of 2020, even after positive vaccine announcements in November resulted in one of the most dramatic rotations from growth to value ever seen. Defensive growth companies lagged the market rally and while the dramatic share price gains of value cyclicals made the news, many high growth equities in the technology space, together with Tesla and innovative healthcare/biotech companies, delivered extremely strong returns to investors.
Taking a wider perspective on the growth versus value debate, it’s certainly true that growth stocks have outperformed for most of the last 13 years, with only brief periods such as the second half of 2016, Q4 of 2018 and Q4 2020, when value delivered any form of meaningful outperformance and these periods to date have been short lived. Many older investors have been brought up on the principles of value investing which relies on mean reversion to deliver returns. Value investors look to try and take advantage of market despondency, or in other words, irrational pessimism by buying stocks at bargain basement prices.
Value investing has come to adopt a low valuation style highlighted by Benjamin Graham, although it has been adopted by some investors such as Warren Buffett to broaden the definition to include more highly rated stocks that still traded at fair prices. In markets today, there is still a subset of value investors who adopt the Benjamin Graham approach and focus on low valuation metrics to the exclusion of most other stock characteristics. It’s important to remember that low valuation parameters aren’t necessarily the same as being under-priced and many of these rigid valuation orientated investors have struggled to a significant degree in the post GFC period. In a world of rapid technological change and business innovation, many of these so-called value stocks have turned out to be value traps because they operate in structurally challenged businesses where companies with an operating weakness will find it more difficult to turn a business around.
One danger with looking rigidly at long term market metrics is that investment regimes and economic fundamentals can change. Long in the tooth investors might remember when it was considered the norm for government bonds to yield less than equities. Equities were risky and during the inflation prone 1970s and 1980s, there was a complete reversal of this thinking, with the belief that inflation risks made traditional fixed interest securities much less safe than they appeared to be, as the real rate of return in a higher inflation world was eroded over time. The post Financial Crisis period has seen once again a reversal of current thinking and now equities yield in excess of government bonds. The point of this discussion is to highlight that investment is a dynamic and changing process and one of the reasons value investors may have delivered historically strong returns has been the lack of research by even institutional investors into many listed companies. I can remember personally using most of my first post-university pay-check from Royal Insurance to invest in a company called Stanley Leisure on a PE of 6x. Over the months that followed, the market realised this was a growth company rather than value play and the shares trebled. When moving on to cover the Irish stock market in the late eighties, it was possible to meet reasonable businesses no investor had met for 2-3 years! Mark Mobius achieved huge early success investing in emerging markets, meeting companies that had never before seen a western investor. In other words, in the earlier days of value investing, it was relatively easy to find growth companies priced by the market at bargain basement valuations, but this is something that is not really present today.
The investment world back when Benjamin Graham and Warren Buffett started out and adopted their value orientated philosophies was considerably different from the current one. Reliable information was extremely hard to come by, with no computers, spreadsheets, or databases. The market was also dominated by private clients, which meant most institutional investors enjoyed a knowledge advantage or information edge, something that is no longer present in today’s world. Disclosure of price-sensitive information by corporates to favoured institutional clients was not even a crime or misdemeanour. With few people searching in a disciplined manner for bargains, it was relatively easy to find them, but today markets have become far more efficient, perhaps helping to explain why many so-called value opportunities have turned out to be value traps. Basic analytical concepts of today, like return on invested capital, competitive moats, and the importance of free cashflow rather than published earnings were not widely appreciated or understood. In summary, for most stocks carrying a low valuation there is probably a good reason for this. There are also indications that successful investing today is reliant on superior judgements concerning qualitative rather than quantitative factors and an understanding of how the world is likely to unfold over the medium term, with a focus on seismic shifts in how economies or corporates operate. (This is very different from short-term forecasting).
The disruption of traditional profit pools has also hit many so-called value opportunities. Markets have become more global in nature and the internet has vastly increased the ultimate profit potential for lots of businesses due to both network and social effects.
The forward-looking nature of today’s markets means it’s now acceptable for companies to lose money in the short term in the pursuit of a large prize down the road, if it seems realistically achievable. With the easier development and scaling of new products, technology companies have been able to further develop new avenues of growth such as Amazon’s AWS division. In today’s world, it seems that the moats protecting winners have never been stronger and this can be seen in the sustained strong revenue growth achieved by many of today’s stock market leaders, with little slowdown in contrast to the world of the 1960s when few companies could maintain a competitive advantage for long periods of time. Value investing does assume the economic principle of ‘perfect competition’ which no longer seems applicable or relevant in today’s world. In other words, today’s conditions mean that profits will not always revert from either above or below the norm; the banking business model best demonstrates this, with the current backdrop of zero or negative rates and flat yield curves, meaning traditional levels of return on equity can no longer be generated.
In an environment of unprecedented technological change and innovation, the application of formulas and investment methodologies that worked in the past has, and is likely to continue to lead to, a misunderstanding of what true value actually is and legendary value investor Sir John Templeton warned that while there could be huge risks when people say ‘it is different this time’, around 20% of the time they are right. One thing seems certain, the purchase of lowly rated stocks, which was once perceived as a defensive way of investing in the stock market, is no longer a low risk option for investors as a greater percentage of these companies are now in terminal decline.
It’s no coincidence that many of the advocates of value are older investors, including perhaps Jeremy Grantham at GMO, who find it hard to believe that truly dominant companies will be able to achieve rapid, durable and highly profitable growth for many years to come. The market leaders of today have demonstrated over the past five years or more that high growth rates are achievable for longer time periods in a technology-enabled world. Businesses with superior technology and corporate culture have obtained long-term competitive advantages with faster growth rates achievable in asset-light business models. This does not mean that all highly rated companies are likely to be successful investments over the next decade, but that some will defy optically high, short term valuations as their long-term prospects are still not fully recognised by the market. A belief in mean reversion encourages investors to what has been described as ‘cutting the flowers and feeding the weeds’ and many investors in pursuit of diversification dilute returns, something that isn’t practiced when listening to music or choosing restaurants. In an environment where certain winning businesses are likely to keep on delivering, running winners is likely to continue to be an important driver of returns for investors who are prepared to live with bouts of short-term volatility. In an environment where there is likely to be a continuation of a narrow list of successful rapidly growing companies with durable competitive advantages, taking profits in these at an early stage will clearly be a mistake as it significantly erodes the inherent asymmetry of equity returns where there is infinite upside but only 100% downside in any share. Loss aversion is an important psychological influence on investor thinking, and for many there is a fear of seeing profits evaporate when logic dictates there is an equal or even higher risk of selling out of a business far too early.
In conclusion, on the growth versus value debate, it’s important to recognise that the world today is different from that of 10 or 25 years ago and that successful growth-orientated investment teams will continue to benefit from the unlimited upside in a limited number of strongly performing equities. Strategies focussed on finding these outliers have the potential to deliver the best returns. Value investing is likely to have periods of outperformance, but without a return to higher levels of economic growth or inflation, their time in the sun may be limited. Many so-called value businesses are in danger of long-term structural decline, making them higher risk investment options today, whereas in the past they might only have been guilty of being an investment option that was extremely dull. This is especially true of those utilising value-investing strategies either totally or highly reliant on low valuation metrics. Today, it’s much harder to ascertain where value actually is, certainly on a quantitative basis, making successful investment linked to superior judgements based on qualitative factors and future long-term trends.
Graham O'Neill, Senior Investment Consultant, RSMR
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