In late 2017, I wrote a little piece with the intention of helping readers to understand the basic underpinnings of value. Close to two years later, it can be observed that growth has delivered much better results than value as a general investment style. Looking at the iShares S&P growth and value indexes for the 2, 5, and 10 year periods ending June 30, 2019 on a gross (i.e. non-annualized) basis, it is clear that value has been left in the dust:
|iShares S&P 500 Growth Index
|iShares S&P 500 Index
|iShares S&P 500 Value Index
The value index selects stocks based on valuation ratios of earnings, book, or sales, while the growth index considers sales and earnings growth, and momentum. If these indexes are valid as representatives of the two general categories’ performance over the past several years, we can say there has been a strong disparity at work. The growing dominance of a group of U.S. technology related businesses is commonly associated with the outperformance of the growth camp. These companies, although widely acknowledged as having strong moats in network effects, do not register on the radar screen of most value investors because they do not trade cheaply on metrics like price-earnings or price-book ratios. That isn’t to say with conviction that they are overvalued or that they do not deserve the values assigned by the market. What I do believe is that every dollar of market capitalization must ultimately be supported by free cash flow. The proof will always be in the pudding. During periods of high growth for a given company, investors may abandon “close to the ground” traditional valuation for market potential. But when the growth rate of these mega-caps slows down, watch out…
Whatever one’s stylistic investment preferences may be, there is an indisputable fact: The more we pay, the lesser our return. Conversely, the less we pay, the higher our return – ceteris paribus. Even if one buys only high quality companies, it is still critical to be sure the price is favorable in relation to future earnings power. Price is always paramount.
Indexation – Threat or Opportunity?
If we were to sample a broad array of investor letters from asset managers over the past few years, we would come across numerous writings exploring trends that are distorting the market’s ability to act as a mechanism to join price and intrinsic value. In particular, the gaining popularity of passive indexation and machine driven trading are often cited for the relative underperformance of value strategies over the past decade.
Could the increase in automated trading and indexation really be the culprit? A Wall Street Journal article in December 2018 outlined that up to 85% of trading volume can be accounted for by entities that do not transact based on companies’ fundamentals. If such an overwhelming proportion of trading is driven by non-fundamental triggers, does this mean we are in a ‘new normal’? As investors continue migrating their savings from actively managed strategies to ETFs (electronically traded funds), a self-reinforcing trend is taking hold. Off-index names undergo selling pressure as investors switch into ETFs. Conversely, the largest constituents in the S&P 500 absorb a disproportionate amount of the ETF buying; these fund flows serve to create selling pressure for managed strategies while providing a tailwind for the largest constituents in the indexes. Investors see the underperformance of active strategies, which spurs more selling – and the dynamic becomes a negative feedback loop.
Even in today’s world of more information and company disclosures than we can process (thanks to the internet), significant and persistent dislocations between price and value abound. I recall speaking to former colleagues who shared stories of riding the subway to public libraries in the late 1980s to obtain company financial statements before everything became available on the internet. With such slow dissemination of data, it makes sense that price would take longer on average to travel to value. And yet today, with data being transmitted literally to our fingertips, stocks can still remain depressed far longer than warranted.
One team that has harvested this inefficiency is Brookfield Asset Management. The CEO, Bruce Flatt, releases quarterly letters that are rich in ‘investment nutrition’. In his Q1 2019 letter, Flatt outlined recent acquisitions of great businesses for reasonable prices, stating that “in many cases, investors are frustrated and fatigued, and therefore choose to move on at a reasonable premium to the share price.” Even at this late stage in the market cycle, entire sectors and certain companies remain out of favor and statistically cheap, though it is important to note single-digit P/E stocks typically do not trade that low for no reason. Thus it is more important than ever to keep checking the soundness of assumptions placed into our valuation work.
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