Growth and Value
Jason Coleman
So far, 2020 has seemed a year of only abrupt and disruptive phenomena: a global pandemic, that sprung seemingly from nowhere, which triggered an immediate (and perhaps lingering) migration of workers from cubicles to kitchen tables, the sharpest sell-off into a bear market recorded, followed by the fastest 50% gain in the S&P on record. Federal reserve policy shifted from a stable to rising rate environment to a nearly manic drive to 0% federal funds rate. It feels like every story is fast, immediate, and now.
What remains fascinating to us as market participants is observing the acceleration and continuation of many trends that existed prior to Covid's arrival on the scene. One trend that has come under our focus is the persistent deviation in the market for returns between the "growth" companies and the "value" companies.
For those unfamiliar, growth and value represent two different ways of thinking about how to pick companies and securities to generate future investment returns. Put simply, value is searching for opportunities to pay 80 cents now to buy $1.00 worth of company. In other words, looking for stocks that are trading for less than what you believe they ought to be trading at and expecting the rest of the market to catch on. This means finding unloved companies without any hype and using them as your springboard for investment success. Warren Buffet once characterized the style of investing as looking around on the ground for old soggy cigar butts and seeing if you could get one last puff out of them. This is not a very appealing metaphor, but accurately reflects how unappealing value investing really can feel; no one wants to be the person looking for soggy cigars. It also makes for bad investment stories at your next (socially distanced) cocktail party.
Growth, on the other hand, is paying $1.20 for $1.00 of company now, in the expectation that it will one day be worth $2.00. Think Amazon, think Tesla, think Zoom and you are thinking growth. Growth investing is premised on the idea that overpaying now works out just fine if the growth in the company's earnings are faster and stronger than current expectations and the price you can sell at later provides a healthy margin for return.
This style of investing is far more intuitive and appealing for most individual investors. For those who started their investing in the 90's, Peter Lynch's "Invest in what you know" mantra was the marching orders for the 90’s growth stock regime (which famously blew its top off in March of 2000). Even before that, the "Nifty Fifty" of the late 60's was full of technology names that were building mainframes, copiers, and a host of other new technologies. There is a natural tendency to align expectations about a company's success with the success of its stock as an investment. Combine this with the very human approach to expecting what is happening now to continue indefinitely and you can see why this style has an easy appeal. These types of investments also make for better stories; everybody would love to be the person that bought Amazon at the IPO and held on for dear life.
The last decade has unequivocally been a decade for Growth investing, led primarily by the "FAANGM" stocks (Facebook, Amazon, Apple, Google, Netflix, and Microsoft). Toss in a few other well-known names: Spotify, Slack, Visa, Nvidia, and others and you've described the pantheon of popular companies in the ought 10's. Going back ten years, the Vanguard Growth Index has advanced over 300%, while the Value counterpart has barely exceeded 100% in price return. This has created historically large discrepancies in valuations for companies in each camp. The Vanguard Growth Index is hovering around a 43 Price/Earnings ratio, while the Value index sits at 18.3 Price/Earnings (which, admittedly, is still above the historical 15-16x earnings average for the S&P as a whole). This trend built slowly over the last 10 years, but certainly accelerated in 2020.
Before moving onto commentary and supposition, it's important to introduce two other facts into the discussion. First, while growth investing seems a natural and obvious way to make money, value investing has historically provided the true edge. Famous research from Eugene Fama and Kenneth French identified the "value" factor in the market as a persistent and robust way to outperform the market indices. In other words, systematically looking for cheap companies has given an investing edge, rather than looking for the high-fliers.
Second, there has been a strong tendency to "mean revert". Mean reversion, truly, is just a fancy way of saying that what goes up must come down, and what gets kicked down will get back up. Good returns will follow poor returns. This has historically been true in the value/growth continuum - most recently after the tech bubble burst in March 2000 and we saw a decade of stronger returns in value. Since the Great Financial Crisis, growth has regained its leadership position and tested the resolve of even the most ardent value investors.
As we build portfolios, then, we must ask ourselves a few key questions to determine positioning. First, what is driving the current deviation in performance? Second, do we believe a "rotation" to value will occur. Third, how would we position for either an outcome towards rotation or against it?
On the first question, what is driving the deviation in performance, we might point to two factors: technology and interest rates. It is not secret that most of the firms in this space are in fact technology companies which often defy the textbook versions of finance. Rather than being a collection of factories and inventories, they largely consist of human ingenuity, trade secrets, and other intangibles. There is a plausible idea that they are simply harder to value than a traditional manufacturing, bank or utility company. Combined with the fact that we have witnessed companies of this type grow very, very quickly in the last two decades could create an environment in which euphoria and expectations are quite high.
Additionally, ultra-low interest rates create conditions for these technology companies to invest and try a massive variety of projects at very low cost. With money available at historically low rates, there is very little cost for companies to borrow to finance all manner of ideas and business models. The opportunity cost as an investor is also very low and provides some motivation to put money on a company with very wide range of expected outcomes in hopes that future earnings will make it a worthwhile investment.
For a rotation to occur, we would likely be looking for a change in either of these conditions. On technology, it seems hard to believe that innovation will slow. There are so many technologies currently working their way along the "hype curve", including artificial intelligence, cloud computing, alternative energy sources, etc. that the pace of new technology coming to market seems to only be quickening. On the interest rate side, the Federal reserve remains committed to keeping rates near zero for at least several more years. Neither of these make a clear case for a rotation in the very near term.
On the other hand, as valuations diverge even further, there becomes a point that the simple “cheapness” of value stocks becomes highly attractive, and we see the mean reversion begin to occur. This could happen quickly (as in March 2000) or over a drawn-out period (such as the bear market following the “pop” of the original Nifty Fifty). It is a matter of mass market psychology when the price for growth becomes simply too much to stomach.
So then, how do we handicap? We believe the answer is this: we remain diversified. Some of the most dangerous words in investing are "this time is different," and we believe this phrase continues to warrant caution. Within reason, we allow the winners - growth stocks, in this case - to run, but use those profits as an opportunity to shore up and prepare the value side of a portfolio. If and when a rotation occurs, our portfolios remain in a position to take advantage. History has shown these rotations can occur extremely quickly and without an immediate proximate cause, so we remain prepared.
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The Vanguard Growth Index Fund (VIGAX or VIGRX) employs an indexing investment approach designed to track the performance of the CRSP US Large Cap Growth Index, a broadly diversified index predominantly made up of growth stocks of large U.S. companies. The Fund attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the Index, holding each stock in approximately the same proportion as its weighting in the Index. The Fund may 2 become nondiversified, as defined under the Investment Company Act of 1940, solely as a result of a change in relative market capitalization or index weighting of one or more constituents of the Index. The S&P 500 Index measures change in stock market conditions based on the average performance of 500 widely held common stocks and is generally considered representative of the U.S. stock market. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. International investing involves special risks, including currency fluctuations, different financial accounting standards, and possible political and economic volatility. Investing in emerging markets can be riskier than investing in well-established foreign markets. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investing involves risk and investors may incur a profit or a loss regardless of strategy selected.
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