Question: According to many market commentators, value investing doesn’t work the way it used to, and some tout statistics that growth has outperformed value over the last decade. How do you rebut that view?
Q1 hedge fund letters, conference, scoops etc
Answer: There are two answers to that question. My first answer is within the bounds of your “growth” and “value” constructs, wherein you take a valuation metric, let’s say price-to-earnings, and divide the market into two halves – the top, expensive half, defined as “growth” stocks, and the bottom (cheap) half, the “value” stocks. That’s a very arbitrary and crude way to look at it, but this is what research services do to make this growth-vs.-value comparison.
Growth companies by definition have higher valuations, as the bulk of their earnings are expected (a very important word) to happen in the future. Thus, just as long-term bonds benefit from low interest rates, growth companies’ valuations expand more when interest rates decline, since their cash flows, which may lie far in the future, are worth significantly more when discounted (brought to today’s dollars) at lower rates. Over the last decade we saw interest rates decline, and so growth stocks did better.
Just remember, low interest rates, unlike diamonds, are not forever.
Value stocks, just like short-term bonds, don’t benefit as much from low interest rates, and thus they have underperformed.
My second answer is a bit more complex. I think value investing is often misunderstood. It is looked upon as the buying of statistically cheap stocks that, let’s say, trade at less than 10x earnings. If counting were the only skill required to be a value investor, my five-year-old daughter Mia Sarah would be a great global value investor. She can count to 100 in both English and Russian.
Value investing to me is a philosophy that is governed by what I call the Six Commandments of Value Investing – all principles that come from the teachings of Ben Graham, spelled out in his book The Intelligent Investor and later popularized by Warren Buffett. I won’t delve into the Commandments here, but you can get a free chapter from my future book that goes through them in great detail, with my own twists – just go to SixCommandments.com.
In short, the value investor approaches the stock market like a smart businessman would if he were buying a business or an office building with the intention of owning it for a long time. If you were approaching stock market investing from this perspective, then you would probably keep away from most of today’s so-called “growth” stocks – companies that are already expensive and just became more even so, priced as if our economy will continue to march uninterrupted by recessions for another decade, unimpeded by the ever-growing mountain of government debt that has historically led to higher interest rates.
If you think the economy is doing great, let me remind you that we have not had a recession in ten years. The Federal Reserve stopped raising interest rates because it was afraid higher rates (that is, greater than 2.5%) would dump us into a recession. Meanwhile, the US government continues to run trillion-dollar annual deficits. So the future may not be as perfect as the expectations (read: high valuations) that are priced into “growth” stocks might imply.
I cannot really talk about “growth” without mentioning the FANGs (Facebook, Amazon, Netflix, Google). These companies are responsible for a very large part of the outperformance of growth. They are all terrific, well-run companies, and their products and services are incredibly popular. If you did not own these stocks over the last five years, you faced a huge headwind in your attempt to outperform the market. Due to their large market capitalizations and their weight in the index, they account for a big chunk of stock market returns).
These companies’ underlying businesses have produced high growth rates for longer than most rational observers would have expected. But the larger they get, the more important the law of large numbers will become, as they are limited by the size of their markets. Everyone in the US (also their dogs and cats) already subscribes to Netflix, and international growth for Netflix is less profitable due to the higher fragmentation of languages (not everyone speaks English – imagine) and lower prices for the service. Google and Facebook are in the advertising business and are going to face the natural constraints of the size of advertising markets and the consequences of what happens to advertising spending during a recession (hint: it is very cyclical).
And then there is Amazon – a sheer freak of a company.
Today everybody knows how great Amazon is. But its stock (just like that of the other FANGs) has already been “discovered” and thus trades at over 60 times 2019 earnings – a valuation that may prove to be a bargain if Amazon’s business continues to grow at the rate it has in the past.
And though I would not want to bet against Bezos (I just don’t want to bet on his stock), I vividly remember how in the late ’90s anyone who doubted Walmart when it traded at 52 times earnings was a heretic scoffing at the repeatability of Walmart’s three decades of enormous success. The thirteen years that followed were not the finest moments for Walmart shareholders – that’s how long it took for the stock to grow into its earnings and to come back to its 1999 high.
At some point Amazon, with its $250 billion of revenues, will suffer a similar fate. But I am not calling the top for Amazon stock for two reasons. First, I have no idea how much fuel (growth) is left in that rocket. Second, just because something is overvalued doesn’t mean it cannot get more overvalued. In May 1999 Walmart stock was at 35 times earnings; a few months later and almost 50% higher, it was trading at 52 times earnings.
Value vs growth? Today it is more than just the debate of cheap vs. expensive. The debate extends much further – can something that cannot go on forever do so? Most people know the right answer to this rhetorical question (in spite of the fact that the stock market can stay irrational longer than most value investors can stay sane or disciplined). I am already seeing FANGs slowly creeping into value investors’ portfolios. Maybe they are beginning to understand the value in the future growth of FANG stocks, or maybe they simply can no longer take the pain of not owning them.
Value has outperformed growth over decades in the past because it is the human condition to be eternally optimistic, to draw straight lines from the past to the future, and to expect good times to roll for longer than they usually do; and thus the expectations that are built into the valuation of growth stocks end up being greater than the reality they eventually face. At the 2018 Berkshire Hathaway annual meeting Warren Buffett said, “You can turn any investment into a bad deal by paying too much.”
So, value investing is not dead, it is just waiting until all value managers lose their hair and capitulate.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).
His books were translated into eight languages. Forbes Magazine called him “The new Benjamin Graham”. To receive Vitaliy’s future articles by email or read his articles click here.
