Full disclosure: I’m a long-time value investor. It’s a discipline I’ve always found to be rewarding even if it hasn’t always been easy. Recent history illuminates the struggle: The Russell 1000 Value Index has lagged its growth counterpart by roughly 4% annually over the 10 years ended Jan. 30, 2020.
The long-term win, however, still goes to value. Over the past 50 years, large-cap value stocks have returned 13.5% annually versus 10.2% for large-cap growth stocks, according to data from professor Kenneth French.
With a relatively strong macroeconomic backdrop and unprecedented disruption across industries, it would be reasonable to infer that the ongoing growth advantage could continue in 2020 and beyond. Successful disruptors are fruitful growers ― and the degree of disruption is only increasing. As shown in the chart below, variations of the word “disrupt” appeared in broker reports for 72% of companies we reviewed at the end of 2019, up from 39% at the start of 2002.
While we expect these trends to continue, we believe focusing exclusively on growth would mean missing out on significant opportunity on the value side of the ledger. We see great potential in both investing styles.
Going for the growth
Massive disruption, whether driven by technology, demographics or otherwise, is testing (sometimes displacing) traditional business models.
The rise of new and disruptive businesses has been a tailwind for growth investors, propelling the Russell 1000 Growth Index 16% annually over the past 10 years. Some worry that valuations are overextended, but we see few red flags. While many of these companies may appear expensive, their ability to compound earnings at an above-market rate suggests they could become relatively more attractive in 12-18 months.
Additionally, valuations for the broad group are not as high as they were at the peak of the dot.com bubble, and on a cash flow basis are not universally stretched. Interest rates are also far lower today, making stock valuations attractive relative to bonds. And importantly, most growth businesses today are exhibiting strong free cash flow, giving them the operational flexibility to absorb shocks.
My colleague and growth guru Lawrence Kemp commented in a recent blog post that the mass digital transformation across industries has allowed tech companies, the bastions of growth, to outperform for several years running. Yet growth and disruption are not central to tech alone. Many consumer discretionary, industrial and health care companies are using new technologies to improve the effectiveness of solutions for customers, lower the cost of doing business and, ultimately, drive earnings growth.
Finding attractive prices while avoiding value traps
For value investors, a key strategy is one of disruption avoidance.
Starting price still matters; this is a non-negotiable truism. But beyond price, and perhaps just as important today, is quality. Low price makes no promise of a sizeable return. In fact, with more disruption comes more value traps ― companies that are cheap and likely to stay that way. The pace of change means business models ― whether long-time standards or promising new ideas ― are increasingly vulnerable to upset.
Value investors today need to focus on durable but underappreciated businesses that are less under attack by the disruptors. How to find them? We look for companies with strong economic moats that can protect profits from disruptors. These moats come from varied sources, including brand strength, market structure, cost positioning, and a robust history of R&D investments.
One sector, two distinct opportunities
To illustrate the opportunity in both growth and value stocks, let’s consider the auto sector. The trend toward ecofriendly alternatives means growth investors are finding rich opportunity in disruptors ― makers of electronic and autonomous vehicles. They are likely focused on companies that are leading their industry, have pricing power, and can take market share from the competition.
Value investors, meanwhile, may look to traditional automakers ― select scale operators that are forward-thinking and have made investments to compete even as combustible engines are being pressured by EV and AV advancements. These companies are vital but may be overlooked in a world focused on the next new thing. Value opportunities may also exist in companies that are suppliers to EVs and AVs.
The mixed message in spreads
In a world where the winners keep winning and the losers keep losing, we’re seeing historically wide valuation spreads ― the difference in price-to-earnings (P/E) ratio between the median stock and value (low-valuation) stocks. In fact, looking back at over 40 years of P/E data for the Russell 1000 Index, we have only seen wider valuation spreads three times ― and two were during recessions.
Meanwhile, credit spreads (the difference in yield between high yield bonds and “safe-haven” Treasuries) are narrow at 3.9% versus a long-term average of 5.4%. A scenario of narrow credit spreads in fixed income and wide valuation spreads in equities is unusual. It tells us that fixed income investors are buying value but equity investors are not. These are often the same companies, but investors are seemingly more willing to buy their junk bonds than their equity. It is worth noting that the earnings of value companies have been doing better than their stock price performance. These disconnects suggest to us that there may be room for valuations to rise.
History indicates that growth and value rarely move in tandem. Ultimately, we believe a robust equity portfolio today can benefit from the best of both breeds: Growth strategies able to identify disruptors with sound long-term business models while cognizant of the importance of free cash flow and valuation, and value strategies that are sensitive to the importance of quality and the risks presented by disruption.
Tony DeSpirito is Chief Investment Officer for U.S. Fundamental Active Equity and a regular contributor to The Blog.
The forward price-to-earnings data cited above for the Russell 1000 Index is from Dec. 31, 1978, to Dec. 31, 2019, and sourced from BlackRock’s Quantitative Alpha Research Group.
Credit spread data cited above reflects the Bloomberg-Barclays U.S. High Yield Index option-adjusted spread from Jan. 31, 1994, to Jan. 31, 2020, and is sourced from Bloomberg.
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