Busting some of the myths of the growth vs. value narrative

December 9, 2020

4:34 pm

A consultant friend of mine recently sent me a link to a blog that I had never seen before, but which contained one of the best articles on the current state of the value vs. growth debate that I have ever read. The blog, called LT3000 Blog is written by an investor called Lyall Turner and the specific article was entitled ‘Unravelling value’s decade-long underperformance (and imminent resurgence)’ and can be found here. I would strongly recommend that you read it in full but below, I have used part of it to challenge some of the myths about value investing currently being put forward (mostly by growth managers).
Myth 1
As the pace of technological change accelerated, we have seen unprecedented levels of disruption to traditional business models and value investors have simply spent a decade riding companies on low multiples, but which are in terminal decline.
This is a great narrative which is mostly used by growth managers (although interestingly I don’t know any value investors who buy low multiple structural decliners) and most of us can think of examples which suggest this is true (Amazon vs. HMV). The question is not whether this has happened in isolated examples but the extent to which it has happened in aggregate. Two notable studies from Cliff Asness here and Rob Arnott here have investigated this claim and found that contrary to popular belief there has been no degradation in returns on capital or earnings for value quintiles. In fact, value portions of the market have done slightly better.
‘Asness’s analysis concludes that the primary driver of value’s underperformance has simply been value getting cheaper and growth getting more expensive, as has been the case in every past cycle where value has underperformed (of which there have been many).’[1]
Myth 2
Disruption is a new thing and that is why value has done badly during the last decade.
Joseph Schumpeter wrote about creative destruction in 1942 but disruption is as old as capitalism from automobiles disrupting the buggy whip industry to light bulbs disrupting candles. All investors, not just value investors, face the possibility of companies being disrupted and arguably this is a greater risk for growth investors for two reasons. Firstly, the high growth rates and returns on capital are more likely to attract new entrants who aim to disrupt the incumbent and secondly, this danger is not priced into stocks. When the market believes a business does not have a viable future it will price it accordingly and those that defy those expectations produce strong returns. Tobacco stocks from 2000 or Microsoft in 2010 might be examples of this.
‘The only constant over time has been continuous change, and value has always faced the headwind of certain companies/industries being disrupted – often fatally. It’s not a question of ‘do some cheap stocks end up getting cheaper – perhaps all the way to zero – and justify their cheapness’, but rather, to what extent does that happen in the aggregate, and to what extend does the lower entry multiples for these stocks compensate for that risk’
Stocks which the market believes are completely resilient to any competitive challenge (the wide stocks so beloved by growth investors) may also be priced for high growth to perpetuity and therefore face significant downside if they disappoint and the market changes its view on their value. The long run evidence suggests that investors under-price stocks with the apparent poor prospects and over price those that seem to offer stability and predictability. In our view, the last decade has not changed this.
‘Examples abound of formerly highly-rated franchises that were part of the high multiple growth and quality parts of the investment universe that suffered massive disruption and falls from grace, and the tendency of a not immaterial minority of highly-rated quality/growth stocks to fail to live up to their expected potential and suffer major de-ratings has been a fundamental driver of the long term underperformance of high multiple stocks as a group. The idea that it is the value portion of the market that is most exposed to disruption is therefore a case that is far from made – intuitive though it may be.’[2]
Myth 3
The outperformance of growth in the last decade is proof enough that value investing is dead.
Whilst the latest period of growth outperformance has been significant and protracted, it is not unprecedented and has happened three times in the last fifty years; firstly the Nifty Fifty Bubble of the late 60s and early 70s, secondly the 90s dotcom bubble and the last decade. There are similarities in the causes on all three occasions whereby a narrative develops about a certain set of stocks that represent a new paradigm. This may be amplified by the media and finance community leading to these stocks becoming highly priced. The second commonality is a background of excess liquidity which inflates the bubble and causes some investors to mistake a liquidity fuelled bubble for investment brilliance. At the peak they might begin to use distorted logic to justify paying almost any price for the growth stars[3] and conversely, they dismiss value investing mistaking ‘has not worked recently’ for ‘will never work again’. At this point a self-reinforcing cycle may start in which value investors suffer redemptions and have to sell their own stock regardless of how cheap they are whilst growth investors receives huge inflows which they use to buy their own stocks regardless of valuation and drive the price up further.
‘As a liquidity driven boom rolls on year after year, investors become increasingly sceptical about the role of valuation, for the simple reason that valuation has proven to be a poor predictor of share prices in recent history. Stocks that looked expensive just kept going up (due to liquidity, which is why they were expensive in the first place), so investors – many of which lack decades of experience – come to believe that focusing too much on valuation is a bad idea. Investors will also point to a handful of big secular winners like CSCO and MSFT (in the 1990s) and AMZN this cycle and note they were ‘always expensive’ and that it was a mistake to pass them up simply because they didn’t trade on low multiples. They will then use this logic to justify paying almost any price for companies of vastly inferior quality, ignoring how unique and uncommon companies like AMZN are, so long as stock prices keep going up and validate the narrative. They are right that valuation is not a good predictor of share prices, but are wrong about why. They think it is because it is growth and business quality driving returns, when in fact it is simply liquidity’.[4]
Eventually these bubbles pop and stocks which investors prized so highly for their defensiveness and predictability end up delivering significant losses as they de-rate to more appropriate levels.
Returns from Nifty Fifty Stocks in 1970s
Source: Exane BNP Paribas Estimates, Datastream, 4 July 2019. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.
Myth 4
This cycle is different because the winners are ‘real companies’ with huge impenetrable franchises unlike the dotcom era.
I hear this claim a lot usually followed by an example like ‘Amazon is not like Pets.com’. This is a completely false comparison. At the height of the Nifty Fifty, we believe investors were just as certain about the future of Xerox and IBM as today’s investors are about Facebook and Google. In 2000, it appeared that investors could not see any way that Cisco, Oracle, Dell, Intel or Nokia could ever be caught by competitors. These stocks ended up losing investors significant amount of money.
“So here we are again, approaching the end (perhaps) of yet another swing of the secular pendulum, where virtually the entire world is long mega-cap tech and other software names, the USD, and defensive high quality (healthcare, staples etc) and defensive secular growth, with valuations near record highs; triple digit P/E ratios have lost their shock value (as have P/S ratios of >30x); all while other parts of the investment universe are generationally cheap with low single digit P/E ratios and 10% dividend yields – some of the greatest value dispersion we have ever seen in market history, period.” [i]
I could not agree with this conclusion more. Investors are currently being offered a wonderful opportunity to buy stocks at prices that could increase the probability of attractive future returns but because they have bought the ‘value is dead, growth stocks can justify any valuation’ narrative, they are not only missing out on a generational investment opportunity but potentially setting themselves for future losses if the gap in valuations narrows.

[1] Source: https://www.aqr.com/Insights/Perspectives/Is-Systematic-Value-Investing-Dead

[2] Source: https://www.aqr.com/Insights/Perspectives/Is-Systematic-Value-Investing-Dead

[3] One growth manager recently produced a chart showing that you could have paid 281x for L’Oreal in 1973 and still made the market return to justify the high valuations currently being paid for growth stocks. Not only does this demonstrate hindsight bias but also uses a small cherry picked sample rather than exploring whether this works in aggregate.

[4] Source: https://www.aqr.com/Insights/Perspectives/Is-Systematic-Value-Investing-Dead

[i] Source: https://lt3000.blogspot.com/2020/11/unravelling-values-decade-long.html

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. This article does not constitute investment advice and the names shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.
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