Growth investors have been well-rewarded over the past decade. For example, the S&P500 index (US market) has delivered an average return of 14.5% p.a. over the past 10 years solely off the back of growth stocks, mainly technology. However, this year to date, value has outperformed growth. If this continues, it could have significant implications for investors.
Value versus growth
A ‘value’ approach involves investing in companies that appear to be under-valued by the market. Investors use a number of ratios to measure whether a company is under or overvalued including price-earnings (PE) ratio, book to market value and so on. The investment thesis is that there is a large body of evidence that demonstrates your starting valuation is a good indicator of future returns. When valuations are low, subsequent returns are high. Such companies also tend to have strong fundamentals including strong cash flow, profitability, strong balances sheets, etc.
A ‘growth’ methodology is less concerned about whether the company is fairly valued by the market. It is all about future potential for growth. Growth investors are encouraged to focus mainly on top line indicators such as user numbers, revenue and growth potential e.g. how big the market could be one day.
Tech has been a big contributor to growth
The large US tech companies have been major contributors to the stock markets growth over the past ten years. The chart below measures how much the FAAMG stocks (being Facebook, Amazon, Apple, Microsoft and Google) have contributed towards the overall performance of the S&P 500 index over the past 1 to 5 years. Over the past 5 years, they are responsible for driving almost half (48.4%) of the index’s return.
If we look at the PE ratios that these FAAMG stocks are currently trading at, we can clearly see that valuations seem unsustainable (Facebook = 31, Amazon = 81, Apple = 36, Microsoft = 38 and Google = 37). To put this in context, the average PE for the S&P 500 has historically ranged between 14 and 18.
Growth has been the clear winner over the past decade
The chart below (published by Dimensional) compares the returns from value and growth since 1926. As you can see, for 84 years (between 1926 and 2010), value was the clear winner. But since 2010, growth has out-performed, particularly over the past 3 years.
But value has performed better this year
One thing that is for certain in financial markets is that outperformance never persists forever. Markets move in cycles. Returns eventually revert to their long-term mean. That means that periods of relative out-performance usually are followed by periods of relative under-performance.
The chart below produced by S&P Dow Jones below illustrates the returns for the 3 months ended 31 March 2021. ‘Pure value’ was the second highest performing factor returning 21%. That compares very favourably against ‘pure growth’ which returned only 0.8% for the period.
In Australia, the performance differential was just as stark. ASX200 Value returned 8.5% for the 3 months ending March 2021 whereas Growth lost 0.09%.
What has changed this year?
It is natural to question why the market has switched from growth to value this year. The simple answer is the best performing sectors this year (Q1 of 2021) were energy, financials, materials and real estate. The worst performing were consumer staples, technology, utilities and health care.
The value index is heavily under-weight in technology and heavily overweight in financials.
To my mind this change has probably been precipitated by the aggressive rollout of the Covid vaccine in the UK and US, and to a lesser extent, Europe. The market is now starting to get a more reliable indication about how far away the global economy is from returning to pre-Covid levels.
Growth portfolios exhibit more risk
Returns are important, but so is risk. A growth portfolio currently exhibits substantially more risk than a value portfolio because growth company valuations are elevated by historical standards. In fact, the US CAPE ratio, which is a reliable indicator of future medium-term returns, is extremely elevated (see here – when the CAPE is above average, future returns will be below average). This makes sense. If you over-pay for a stock, the only way you can make a profit is if the stock value keeps rising. But the higher its price gets, arguably, the lower the likelihood the price will keep rising, especially if it’s not supported by higher earnings.
However, most of these lofty valuations are centred in just a few sectors most notably consumer discretionary (thanks to Amazon) and technology, whereas financials are relatively cheap. By adopting a value approach, you avoid the riskiest companies and sectors in the market, particularly if you agree that some of these valuations are unsustainable.
Will this trend continue?
Will value continue to outperform growth? The short answer is no one knows.
The longer answer is that growth has outperformed value by 2.3% p.a. over the past 10 years, and by more than 21% p.a. over the past 3 years. Over the past 2 to 3 years, I have been tilting my client’s portfolio towards value, mainly to reduce risk but also to generate higher returns. I have been doing this because historical evidence demonstrates that growth will not outperform forever. At some point the market will realise that you cannot make money in the long-run if you pay over 1,000 times annual earnings for a company (e.g. Tesla). I don’t know when that will be. But 95 years of data/evidenced demonstrates that tilting towards value will likely yield better returns over the next 5 to 10 years. The key is to:
- Avoid the temptation to attempt to “pick” short term trends. Medium to longer term trends are far easier to identify; and
- Don’t take massive bets. Don’t invest 100% of your funds in ‘value’. Diversify.
Value options are limited
Unfortunately, there are limited value options for retail investors. There are a couple ETF’s which provide global exposure (being VVLU and VLUE). The only ETF that gives you Australian exposure is QOZ which uses fundamental indexing. I’m not recommending these investments of course, just highlighting they exist.
In fact, it’s very important to highlight that there are many low-cost, rules based managed funds that use proven value methodologies that will probably never be available in an ETF format. This is why it’s important to receive independent financial advice, to ensure your portfolio is structured correctly to minimise risk whilst maximising future returns.