Since the inception of the stock market, investors have witnessed a continual tug of war between value investing and growth investing styles. History repeats itself, with 10-year (plus or minus) swings where one investment style dominates. So goes the current pattern, with growth investors benefitting from a strong run over the past thirteen years starting in 2007 (the MSCI World Growth Index outperformed its value counterpart by 170 percentage points from 2010 to 2020). The most recent four years of this cycle have shown massive growth acceleration, capped by 2020 when the Growth Index beat the Value Index by 34 percentage points. Growth Index companies saw earnings grow 10%, but valuations grew 60%. Why? Enthusiastic investors bid up tech high flyers, pricing in big earnings growth far into the future helped by lower bond yields, making far-distant profits even more valuable. One prominent example of the multiple expansion: Apple traded at 15x earnings in 2018; less than 3 years later, it traded at 30x earnings. The valuation spread between the MSCI World Growth and World Value indices is the largest since the 2000s dot-com bubble, with a roughly 17-point difference in price to earnings ratios between the indices. At two standard deviations above its historical mean, such periods have historically been associated with subsequent value outperformance.
Also helping the reversion to value: the arrival of a coronavirus vaccine allowed investors to refocus on stodgy value stocks that faced headwinds during COVID-19. In the first six months of the year, the S&P 500 was up 14%, led by energy, financial and commodity companies that limped through last year’s economic collapse. While many an investment pundit has regurgitated these data points ad nauseum to every news outlet, little has been done to explain how growth dominated for so long, or why value will make a resurgence in a 2021 bull market. We seek to do so here. In a Q&A with Polaris analyst Sam Horn, we discuss competing market dynamics and underscore why investors should jump on the value bandwagon now before the value-growth disparity comes full circle.
A: Empirical studies by McKinsey & Company show that growth decays very quickly for a typical company; high growth is not sustainable under the law of large numbers. Revenues can only grow so much for so long, until high growth companies start to mature. According to McKinsey, on average after four years, a combined basket of high growth companies should ultimately decrease to an average growth range of 4-6% in nominal terms (or 2-4% real). We agree with McKinsey, as we think a 2% real growth rate is a sustainable assumption (1% population growth and 1% productivity gains).
Apple certainly doesn’t abide by this modest growth rate assumption. Rather, shares doubled in a year (2019-2020), and as of August 2021, the current stock price hovers around $150.00 a share, making Apple a $2.4 trillion market cap company. Yet, most of this boost came from multiple expansion and not from underlying cash flow growth. Can Apple really double its cash flow from here to justify the valuation? It’s hard to see… and that is at the core of the McKinsey study. Just by the law of large numbers, a two trillion-dollar company can’t continue to grow at a pace that justifies the Apple valuation. Still, we see many investors are using an inflated growth assumption in combination with a lower discount, and that is how you get to the unrealistic valuation.
Competition for a limited amount of revenue will play a part in normalizing valuations. We see many legacy network companies such as Discovery, Warner Media, NBC, ABC, etc., throwing money into generating content to drive the growth of their streaming platforms. These legacy players are making inroads at growing their subscriber numbers while also stemming the growth in users of Netflix. The market realized now that Netflix’s domestic market is maturing and the valuation cannot justify the current growth rate. Year to date (through September 2021), we are seeing some growth stocks (Peloton, -29%; Snowflake, -1%; Netflix +1%; Amazon, 0%) moving sideways or tumbling because of a slowdown in earnings growth.
A: Yes, we are at an inflection point in this historic growth-value dispersion. Many companies that have survived the COVID-19 recession are now entering the early stages of a new bull market, with inflation rising. The Fed calls for “transitory inflation”, which means that the consumer price index (CPI) will increase, but will not leave a permanent mark on inflation. Whether this proves true or not, it has become evident that inflation is here to stay, with the CPI rising 5.4% in July 2021 from a year earlier. The Fed can’t keep printing money forever or keep interest rates artificially low with this much inflation in the economy. Ultimately, the Fed will have to raise interest rates. As stated earlier, mathematically, the discount rate will then go up, and growth stocks will decline because the current value of the future cash flows will be worth much less. That is why we saw a steep sell-off in March 2021 and again in June 2021, when the Fed hinted at possible rate hikes in 2022.
Inherently, value stocks will start to run on higher inflation and renewed pricing power, along with new infrastructure spending and early stages of economic expansion. Cyclical value sectors, like materials and financials, are primed for success. In the case of financials, the steepening of the yield curve boosts banks’ net interest margins, as banks generally borrow short-term and lend long-term. We expect banks to start returning capital to shareholders (buybacks and dividends), no longer wary about mortgage defaults and bankruptcies. As commodity prices rise, companies selling these materials are in a perfect position. For example, copper prices climbed markedly for the first time in more than a decade as investors bet that the economic rebound will drive demand for industrial metals; iron ore prices have also hit records. We also see tangential beneficiaries of higher prices; in talking to our portfolio companies on a weekly basis, many are echoing the same sentiment. Yes, we’re seeing higher raw material prices (lumber, steel, iron ore) but are baking those costs into higher pass-through prices. Since these cycles typically are multi-year and we are at the initial stages of the expansion, now is the time to take advantage of this trend in materials, industrials and consumer discretionary, where our portfolios have overweight positions.
A: This rotation should have legs — particularly in light of better relative valuations for value stocks, prospects for economic growth, and the likelihood of inflation (which disproportionately hurts growth and tech stocks). However, the tug of war evident in the second quarter of 2021 is likely to continue and the progress of value stocks might take place in fits and starts.
Another important point: once COVID-19 abates and inflation continues to rise, analysts will revise down estimates and growth stocks will take it on the chin. The benchmark is so concentrated around these FAANG growth names that once expectations aren’t meant and they start printing bad numbers, inadvertently, the index itself will come down. Those stocks not aligned with the benchmark will likely do much better; many of those are smaller cap value names. And truth be told, many values names are now producing cash favorably and are in better shape on a fundamental basis. Most companies negatively impacted by COVID-19 proactively implemented cost-cutting measures and shored up their balance sheets. The same cannot be said for most growth companies, after depleting money on advertising and market budgets and aggressively hiring in hopes of attracting customers; bottom line cash flow proved an afterthought. Ultimately, investors will realize the promise of lofty assumptions and estimates are just that; the market will come back to the undervalued companies that we hold so dear.
A: It is worth reiterating that over the long run, value outperforms growth despite having periods of underperformance. There is plenty of historical proof to this effect. Data covering nearly a century in the U.S. and 50 years in non-U.S. markets supports the notion that values stocks have higher expected returns. Since 1926, value investing has returned 1,344,600%, according to Bank of America. During that same time, growth investing returned just 626,600%. Other data: On average, value stocks have outperformed growth stocks by 4.54% annually in the U.S. since 1928. I would point to a great graph from Dimensional (updated February 2022), demonstrating the annual returns of value and growth since 1928:
The moral of this story: stick with value stocks. During times of underperformance, value stocks quickly sell-off and then quickly outperform on the upward recovery. So while the volatility might be hard to stomach during the period of underperformance, maintaining your position is important because the recovery more than makes up for the underperformance.
This blog was penned by Sam Horn, Senior Investment Analyst, in December 2023. Mr. Horn initially joined the firm in 2012 and re-joined Polaris in August 2016 as an Analyst, after completing his MBA from the MIT Sloan School of Management. He was promoted to Senior Investment Analyst in January 2021, and became an LLC member in January 2022. He continues to work with an experienced research team, performing fundamental analysis of potential investment opportunities.
Polaris Capital Management LLC is an investment advisor registered with the U.S. Securities and Exchange Commission (SEC). Polaris' website provides general information regarding our business along with access to additional investment related information. Material presented is meant for informational purposes only. To the extent that you utilize any financial calculators or links in our website, you acknowledge and understand that the information provided to you should not be construed as personal investment advice from Polaris or any of its investment professionals. For additional information regarding our services, or to receive a hard copy of our firm's disclosure documents (Form ADV Part I and Form ADV Part II), contact client service. You may also obtain these disclosure documents online from the SEC Investment Adviser Public Disclosure (Firm CRD# 106278). (c) 2013-2024 Polaris Capital Management, LLC. All rights reserved.
IMPORTANT INFO: RETIREMENT CALCULATOR
The retirement calculator is a model or tool intended for informational and educational purposes only, and does not constitute professional, financial or investment advice. This model may be helpful in formulating your future plans, but does not constitute a complete financial plan. We strongly recommend that you seek the advice of a financial services professional who has a fiduciary relationship with you before making any type of investment or significant financial decision. We, at Polaris Capital, do not serve in this role for you. We also encourage you to review your investment strategy periodically as your financial circumstances change.
This model is provided as a rough approximation of future financial performance that you may encounter in reaching your retirement goals. The results presented by this model are hypothetical and may not reflect the actual growth of your own investments. Polaris strives to keep its information and tools accurate and up-to-date.
The information presented is based on objective analysis, but may not be the same that you find at a particular financial institution, service provider or specific product’s site. Polaris Capital and its employees are not responsible for the consequences of any decisions or actions taken in reliance upon or as a result of the information provided by this tool. Polaris is not responsible for any human or mechanical errors or omissions. All content, calculations, estimates, and forecasts are presented without express or implied warranties, including, but not limited to, any implied warranties of merchantability and fitness for a particular purpose or otherwise.
Please confirm your agreement/understanding of this disclaimer.
DISCLAIMER: You are about to leave the Polaris Capital Management, LLC website and will be taken to the PCM Global Funds ICAV website. By accepting, you are consenting to being directed to the PCM Global Funds ICAV website for non-U.S. investors only.
