“Low interest rates have made it very cheap for companies to grow. Higher ROI will outperform when capital becomes more expensive.”
David Poppe, Sequoia Fund’s CEO, on why value stocks have underperformed growth stocks.
Stretched valuations are abundant in equity markets.
Specifically, the Biotech sector has ballooned - from July 2009 to the peak in July 2015, the Biotech index was up 482%. According to Renaissance Capital there were 192 IPOs raising more than $14.7 billion. Most of these companies are development stage businesses, have never earned money and most never will. Despite that, these companies have lofty market valuations as investors bet on the next blockbuster drug.
Technology is also trading at bloated valuations with the “FANGs” (Facebook, Amazon, Netflix, Alphabet) up an average of 83% in 2015. These stocks are trading at 40x, 133x, 313x and 19.5x earnings, respectively.
Growth style investing has outperformed Value in recent years. Looking at the previous periods where Growth has outperformed, we see that Growth dominates in environments where earnings growth is weak and interest rates are low and stable.
Since 2009, the market backdrop has been conducive for Growth investing with interest rates stable at historically low levels since the Global Financial Crisis (GFC).
S&P 500 earnings have been anemic since 2014 growing at less than 1% per year. Since 1945 there have been 6 periods when Growth has outperformed Value.
Source: Fama/French US Research Returns Data http://mba.tuck.dartmouth.edu/pages/faculty/ ken.french/data_library.html
The areas in green represent periods of Value’s outperformance. You can see that we are in the first Growth cycle since the internet bubble. Due to the extended low inflation environment, this Growth cycle has lasted longer than previous cycle. Investors should prepare for a change in leadership. US inflation is running above 2.0% and expected to move higher over the next 9 months, reaching a potential 2.5% by the spring of 2017.
At the same time, earnings which have been flat for the past 2 years, are expected to grow in H2’16 by 4.2% and in 2017 by more than 13.6%.
In fact, the S&P 500 Growth and Value Style Indices are confirming our analysis with the value index outperforming growth since the market lows in February 2016.
Looking at prior periods where Growth has outperformed, Value has subsequently recovered, Outperforming growth by roughly 5% per year for 5 years1. The strength and length of the recovery explains why Value investing has outperformed Growth over time.
Lately investors have expressed concern about the markets valuation as reason to not to add capital to their equity holdings. We’d point out that in 1999, the S&P500 began the year trading at a PE of 32.9x. Through until 2005, the market returned only 13.8% (2.3% per year) whereas our US manager, Kingwest & Company, returned over 100% (16.8% per year).
Furthermore, from a fundamental perspective today, the Kingwest US portfolio is valued at a 40% discount to its intrinsic value, based on their assessment. This means that the next few years should produce strong returns.
JP Morgan’s Quant team published a note on July 21st focusing on style analyses. They concluded:
Our regional (USA, Europe & Asia Pac/EM) Quant Macro Indices - QMI are all pointing to the ‘recovery’ phase of the cycle. Globally and across the regions our strongest style conviction during this phase, is to be overweight Value stocks. In contrast, the risk reward towards Momentum and low Volatility stocks now appears to be diminishing and is overall unattractive based on lofty valuations, extreme investor positioning and less negative macro signals.
Going forward, we expect markets to climb the proverbial ‘wall of worry’. Growth and Income stocks have become stretched. Limited growth opportunities and historically low interest rates have fueled these segments of the market.
The time to buy Value is now.
founder of Anassa Partners, which acts as the exclusive distributor in Switzerland for the Kingwest & Company’s US and Canadian Equity fund and SMA Gestion’s European Equity and L/S fund. These managers have high active shares, low turnover and significantly better performance than their indices. For more information visit us at www.anassa.ch.
1 Source: Euclidian Technologies, It’s Time to Add Capital to Your Value Fund, August 2015
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