The Best Investment Value Today May be Value, Itself

The history books will show no Wimbledon champion in 2020, no Boston Marathon winner, no Final Four participants, and no 2020 Summer Olympic medalists. Just a lot of asterisks. A graph of crude oil prices will show a point in April 2020 when the price fell below zero. 2020 college transcripts – in many cases – won’t have traditional letter grades – just a P or an F for pass or fail. Economic charts – like those for weekly unemployment claims – have been forced to dramatically expand the y-axis to incorporate the data plots for 2020. 

You are likely tired of hearing about the unprecedented events and incredulous aberrations of 2020. With this in mind, we apologize in advance for the following (and for the preceding). Given all that has transpired this year, it is entirely understandable that one of the most examined, discussed, and debated stories within the institutional investment world in 2020 has gone largely unnoticed by most retail investors. While the election, the economic recession, Covid-19, and the stock market volatility continue to garner the attention of mass media, it is the historically unprecedented disconnect between value and growth stocks that earns attention and debate deep within investment circles in 2020.

This is a good time to pause and explain:

1. What is meant by “value stocks” and “growth stocks”;
2. How unprecedented the value-growth disconnect is;
3. What has caused the disconnect; and
4. What specifically this means going forward.

What Is Meant by “Value Stocks” and “Growth Stocks”? 

I recently explained one of the most fundamentally misunderstood investing concepts to my kids: that when evaluating the cheapness or expensiveness of a stock, the stock’s price – in isolation – is literally of zero value. Zilch. I went on to explain how a stock priced at $3,000/share might be dramatically cheaper than a different stock priced at $1/share to engrain this concept.

When we own a share of stock, we own a percentage of the underlying company’s assets, future revenues, cash flows, etc. And when we evaluate whether a stock is cheap or expensive, we should compare the price per share to the cash flow per share, the earnings per share, the book value per share, the revenues per share, or some other fundamental measure.  

Furthermore, when we evaluate stocks using a ratio where price is the numerator and one of these fundamental measures like earnings is the denominator (such as price / earnings), value stocks are those that trade at a below average ratio. Conversely, growth stocks – which is just a pleasant way of saying expensive stocks – are the stocks that trade at an above average ratio.

Value stocks are companies such as Colgate-Palmolive, Campbell Soup, and Hanesbrands that sell boring, low-growth, low margin products like dish soap, toothpaste, chicken noodle soup, and underwear. Value stocks often have significant issues within their business that makes them cheap. Conversely, growth stocks are companies such as Apple, Amazon, Google, and Tesla. They tend to have an exciting narrative and trendy products.  

Most investors get far more excited about the second group of stocks than the first. This is a big part of why the story plays out as it does. Value investing owes some of its success to the lottery preference of human brains – an inherent behavioral desire we have to prefer long-shots at the racetrack or an exciting technology company with the small potential of a 20x return. Investors, as a result, pay more than they should for trendy growth stories or 100-1 race horses which, conversely, drives down their expected return.  

You may also be familiar with the concept of recency bias – the behavioral tendency of humans to extrapolate the recent past into the future. Recency bias in investing is a real thing and results in investors overestimating the persistence of high growth or high profitability. The historic reality is that growth and profitability are not very persistent because competition in a capitalist society erodes any profitability or growth advantage over time. Conversely, investors underestimate the ability of companies with depressed profitability to exceed the depressed expectations in the future. As a result, growth stocks often fail to live up to the implied expectations (which means they tend to be overpriced) and value stocks often tend to exceed the lowball expectations (which means they tend to be underpriced).

The Historic Disconnect Between Value and Growth Stocks

We just described some of the explanations for why value stocks should outperform their more expensive counterparts but does the historical data support these theories? Nearly a century of market data reflects the following: Investing in value stocks tends to result in a performance advantage of several percent per year relative to investing in growth stocks. Between 1927-2019, value stocks outperformed growth stocks by a calendar year average of 4.4%¹. The historical evidence is persistent (value works across long periods of time), pervasive (value works across sectors, countries, regions), and robust (value works across different measures such as price/book, price/earnings, etc.).

The economic advantage of value investing over time should be clear from the charts above. While not a free lunch that “wins” every day or every year, value investing has rewarded long-term investors with a very sizeable economic advantage. The value premium is not something that just exists in the US. It has been persistent and robust around the globe².

Yet over the first eight months of 2020, value stocks underperformed growth stocks by the largest calendar year margin ever (39.0%)³. The previous worst underperformance of value stocks came during the heart of the tech boom when growth stocks beat value stocks by 24% in 1999. The growth-value performance gap in 2020 runs circles around even the dot.com boom. It has not just been a 2020 phenomenon. Growth stocks have outperformed value stocks over the past decade by the widest margin ever: 8.8% per year as of August 31, 2020.

What Has Caused the Value – Growth Disconnect

The historic departure of the value premium have investors and academics asking the hugely important question: Is value investing broken?

Much has been written and said to address this question. If we are being intellectually honest, then we have to occasionally retest our hypotheses and question our assumptions in all facets of investing. And so we must assess whether value investing should have the same success in the future as it has in the past.

There are several rational theories that seek to explain the recent demise of value investing and for sake of brevity, here is a summarized narrative of each:

• Overcrowding Hypothesis: The return premium of value investing is well documented and popularized such that value investing has become overcrowded, thereby eliminating any premium in the future. The problem with this hypothesis is that value stocks have become significantly cheaper relative to growth stocks and the valuation spread has expanded. Were value investing to become overcrowded, we would have expected the valuation spread to have declined.
• Low Interest Rates Hypothesis: The perceived attractiveness of growth stocks tends to rely heavily or entirely on future cash flows (think of companies like Tesla, Snapchat, or Uber that are losing money now but anticipation of high profits in the future). These future profits have to be discounted to arrive at a present value. When interest rates decline – as they have for the past decade – the lower discount rate (or opportunity cost) results in a higher present value for those future cash flows. This hypothesis isn’t necessarily an argument that value is dead or broken – just that the declining rate environment of the past decade has favored growth stocks. If true, then any increase in interest rates in the future would be favorable for value stocks and unfavorable for growth stocks. And while this may provide a compelling explanation for the recent trend, the empirical data does not support this hypothesis.
• Conservative Accounting Hypothesis: The growing importance of intangible assets (think intellectual capital or successful clinical trials) that are not reflected on financial statements makes many growth stocks look artificially expensive and diminishes the benefit of valuation measures. While a valid criticism for some valuation measures (like price / book value), there are plenty of valuation measures that correct for or ignore these conservative account discrepancies. Using measures that define value and growth stocks without regard for intangible assets does not change the historically robust success of value investing.  

None of the popular hypotheses to explain the divide between value and growth performance really holds up when the underlying data is tested. Furthermore, the underlying data does not demonstrate that growth companies are any more profitable or that value companies are any less profitable. In fact, the profitability of growth stocks relative to value stocks has actually declined by 1% over the past 12 years. In isolation, this should have caused value stocks to outperform growth stocks during that stretch.

So, if value investing is not broken, what then explains the dramatic performance gap? In our view, Occam’s razor does. The simplest explanation appears to be the one that best explains the value-growth spread.

Specifically, the performance spread between value and growth seems driven simply by value stocks getting cheaper and growth stocks getting more expensive. Borrowing a line from fund investor Cliff Asness, “Investors are simply paying way more than usual for the stocks they love versus the ones they hate.” The charts below reflect the historically expensive valuations of growth stocks or – said differently – the historical cheapness of value stocks. The top chart shows that growth stocks in the United States are 6.0 standard deviations above their historic average valuation as compared to value stocks⁴. The bottom of the two charts shows the same historic expensiveness of growth stocks relative to value stocks outside the United States.

What This all Means for the Future

While it is not unprecedented for growth stocks to beat value stocks over extended time periods, the duration and magnitude of this growth outperformance is unprecedented on many counts. What’s more important than this historical data is where we stand today and what it all means going forward.

Depending on what metric we use to measure the valuation of value stocks relative to growth stocks, value stocks are trading somewhere between really cheap and their cheapest level ever. While these relative valuation measures are not useful as short-term trading indicators (because really cheap stocks can get even cheaper and really expensive stocks can get even more expensive), they are helpful as long-term allocation tools.

In the book Expectations Investing, revered investor, professor, and author Michael Mauboussin provided a succinct and powerful explanation for why value investing works:

Having been on the sell side for many years and then on the buy side, I can say categorically that the single greatest error I have observed among investment professionals is the failure to distinguish between knowledge of a company’s fundamentals and the expectations implied by the company’s stock price. If the fundamentals are good, investors want to buy the stock. If the fundamentals are bad, investors want to sell the stock. They do not, however, fully consider the expectations built into the price of the stock.

There is this perception among retail investors that if you buy great companies, you will do well as an investor. Nearly a century of data debunks this myth and yet – to Mauboussin’s point – investors continue to buy into it. To be clear: it is not about how great the company is. It has always been about how much you pay. It is about what expectations are built into the price.

In our view, the evidence suggests that investors are increasingly ignoring the expectations built into stock prices – overpaying for great companies and underpaying for the less great companies. We are not alone in suggesting that this is perhaps the single most important trend in the stock market. While there is no time table for how long the trend may continue, an eventual reversion seems likely. And if it is anything like reversions of the past, value investors are positioned to be handsomely rewarded.

1. Source: Ken French Data Library. Portfolios formed on book/market. Value represented by 30% of stocks with highest book/market. Growth represented by 30% of stocks with lowest book/market.
2. Data reflects Fama/French Value and Growth Indices for each market.
3. Source: Ken French Data Library. Portfolios formed on book/market. Value represented by 30% of stocks with highest book/market. Growth represented by 30% of stocks with lowest book/market.
4. Source: Ken French Data Library. Portfolios formed on book/market. Value represented by 30% of stocks with highest book/market. Growth represented by 30% of stocks with lowest book/market. Data represents book/price of value stocks divided by book/price of growth stocks and measured as a z-score