According to many market commentators, value investing doesn’t work the way it used to. Some even tout statistics that growth-stock strategies have outperformed value over the past decade. How do you rebut that view?
There are two answers to this question. My first answer is within the bounds of your “growth” and “value” constructs, where 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 an 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 key 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 past decade interest rates have declined, so growth stocks did better. Just remember that low interest rates, unlike diamonds, are not forever.
Value stocks, like short-term bonds, don’t benefit as much from low interest rates, and thus 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 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 Benjamin 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 read a free chapter from my future book that goes through them in great detail, with my own twists, at SixCommandments.com.
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In short, the value investor approaches the stock market in the way a smart businessman would if he was buying a business or an office building with the intention of owning it for a long time. If you regarded stock market investing from this perspective, then you would keep away from most of today’s so-called “growth” stocks — companies that were already expensive and overvalued but just got more so, priced as if our economy will continue to march uninterrupted by recessions for another decade and 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, and meanwhile the U.S. government goes on running trillion-dollar annual deficits. So, the future may not be as perfect as the expectations (high valuations) imply that are priced into “growth” stocks.
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I cannot discuss “growth” without mentioning the FANGs (Facebook, Amazon.com, Netflix, Google). These companies are responsible for a large part of the outperformance of growth strategies. They are all well-run companies, and their products and services are incredibly popular. If you did not own these stocks over the past 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 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. For example, it seems like everyone in the U.S. subscribes to Netflix NFLX, +0.66% , while international growth for Netflix is less profitable due to the higher fragmentation of languages and lower prices for the service. Alphabet’s GOOGL, -0.93% Google and Facebook FB, +0.40% , meanwhile, 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 highly cyclical).
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Then there’s Amazon AMZN, +0.52% — a sheer freak of a company. Everybody knows of Amazon’s greatness. But its stock (just like that of the other FANGs) has been “discovered” and nowadays trades at more than 60 times 2019 earnings — a valuation that in fact may 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 1990s anyone who doubted Walmart WMT, +1.81% when it traded at 52 times earnings was a heretic scoffing at the repeatability of Walmart’s three decades of enormous success. The 13 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 revenue, 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.
Today, value vs. growth is more than just the debate of cheap vs. expensive. The debate spills 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 seeing FANGs creeping into value investors’ portfolios. Maybe they are realizing the value in the future growth of these companies — 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 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.”
Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver, Colo., which has no position in any of the stocks mentioned in this article. He is the author of “Active Value Investing” (Wiley) and “The Little Book of Sideways Markets” (Wiley).
How does one invest in this overvalued market? Our strategy is spelled out in this fairly lengthy article.