SEPTEMBER 21, 2021: Is value investing ready for a comeback?
By Sam Horn, Senior Investment Analyst
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: There are many variables relating to the growth momentum; it would be hard to single out any one cause for the outperformance. Rather, it is some combination of reasons, resulting in the perfect storm for an overheated growth market. Among those, in no order of preference, would be:
- Low interest rates: Valuing a business using the discount cash flow (DCF) formula is simple. Some investors use the current interest rate to discount the future cash flows of a business. Mathematically speaking, a low interest rate lowers the denominator in the DCF, which in turn increases the worth of future business earnings in today’s money. Since most growth companies’ cash flows are far out in the future, the value is worth more due to discounting these cash flows at a lower rate.
- Yield curve inversion: 2019 went down as the year of the yield curve inversion, when short-term U.S. Treasuries offered higher yields than longer-term ones (for nearly five months). Institutional investors had to search for yield to close the gap on their underfunded pension liabilities. They couldn’t find money in high-yield bonds, so they had to stretch into equities. Billions were plowed into index funds made up of a concentrated basket of mega-cap technology companies (FAANG stocks – Facebook, Amazon, Apple, Netflix, Google (Alphabet)).
- Earnings up: We must give credit where credit is due. Many growth companies did grow earnings in real terms (excluding inflation), while many value stocks lagged or were subject to disruption over the past few years. Microsoft is a great example, growing free cash flow on a fully diluted basis. The tech company grew at a 13-year compound annual growth rate (CAGR) of 10% nominal and 8% real (2% inflation). Comparing Microsoft with a traditional value name like J.M. Smucker, the consumer staples company grew its cash flows 5% nominal or 3% real per annum over the same 13-year period. For reference, the S&P 500 grew at a CAGR of 6% nominal, 4% real for the same period.
But comparing cash flow growth to the stock total return requires caution. Microsoft grew cash flows at 8% real, yet the stock returned 23.12% – nearly tripling the cash flows metric. By comparison, J.M. Smucker (with 3% cash flow growth) had a modest 8% total return and the S&P 500 Index (an amalgam of growth and value stocks) had a 10% real total return on real cash flows of 4%. While the cash flows of Microsoft did grow nicely in real terms, the total return was much higher due to multiple expansion. Therefore, the only two explanations for the higher valuation: 1) the future expectation of the cash flows is higher and/or 2) investors are using a lower discount rate because the perceived riskiness of these cash flows is lower. - COVID-19 disruption: Tech companies that made remote living possible — or even bearable — were the center of the action last year as investors sought stocks that were either immune to the economic chaos of the pandemic or potential winners in a lockdown environment. As a result, many tech and online businesses pulled forward earnings and cash flows, with disruptive technology experiencing sizable earnings growth (i.e. Zoom, Slack, DoorDash, Peloton).
- Excess liquidity: With the Fed printing money to stabilize the economy, there was plenty of liquidity in the system. Capital should flow to the highest yielding asset(s); however, we saw investors put their money into lower-yielding assets in today’s terms as they bet heavily on the future prospect of business, which ultimately is a higher risk investment than the former. Private equity and venture capital firms with excess cash backed start-ups of every type (Beyond Meat, Lyft, Snowflake), bringing loss-making companies into the public market with exuberant valuations as part of a broader exit strategy. There were a record number of Special Purpose Acquisition Company (SPAC) deals like Virgin Galactic, sports betting company DraftKings and Hims&Hers Health, basically allowing private firms to bypass the traditional IPO process. Bill Ackman raised $4 billion in capital through a SPAC, the largest on record, with an unknown investment plan. Retail investors also participated in the market run-up, as some opened up commission-free Robinhood trading accounts and bid up the likes of GameStop and AMC Theaters in so-called “meme” mania. Investors also plowed money into newly formed digital assets from Non-Fungible Tokens (NFT) to cryptocurrencies.
The excesses in the system are clearly visible: record high housing prices (up 40% in Arizona) in pockets across the U.S.; NFTs that sell for millions ($69 million Beeple); and AMC +2,000% YTD performance. Consider stationary bike and streamed workout company, Peloton, which generated nearly $2 billion in revenues in 2020 during the at-home cycle frenzy of COVID-19. Peloton stock currently trades at levels of close to $130 per share, valued at about 8x projected fiscal year 2021 revenues. But to legitimize Peloton’s current valuation (even after a 20% drop in mid-April 2021 due to treadmill recall concerns), Peloton’s sales must reach $4 billion in 2021, then double again in 2024 – a far stretch, especially without the COVID-19 driver. Tesla is another example, with a market cap that is more than the combined value of every other auto manufacturer worldwide. A July 2021 article in Forbes said it best: “At a lofty price-to-earnings ratio of 25, Tesla would need to achieve net profits of $51 billion a year. Getting from the current $4.6 billion to $51 billion would demand profit growth of 41% a year. Today, the only U.S. companies earning in the $50 billion range and over are Apple, Microsoft, Alphabet, Berkshire Hathaway, and JPMorgan Chase.” Look at Zoom. At its height in October 2020, the market cap of the video conferencing platform exploded by 800% in the 18 months. Zoom had grown to be bigger than 15 of the world’s largest airlines combined. And there are many others with outsized valuations, where companies need to grow cash flow at 10% per annum for the next 50 years in order to justify the current price. Basically, growth assumptions for these companies are extremely high off of a very high base. I don’t believe this is sustainable.
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 Samuel Horn in September 2021. Mr. Horn 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, all of whom are considered generalists, and perform fundamental analysis of potential investment opportunities.
DISCLAIMER: The value investing views in this article were those of Samuel Horn as of the article’s publication date (September 20, 2021) and may be subject to change. Information, particularly facts and figures, are dated and in many cases outdated. Views and opinions of Samuel Horn expressed herein do not necessarily state or reflect those of Polaris Capital Management, and are not nor shall be used for advertising or product endorsement purposes. Polaris Capital is an investment adviser registered with the Securities and Exchange Commission. For more information about Polaris, please contact us at (617) 951-1365 or at clientservice@polariscapital.com
