The classic investing strategy of picking stocks with cheap book valuation, embraced by the legendary Warren Buffet and created by Benjamin Graham in the Great Depression, has become increasingly irrelevant thanks to central banks and technology, according to Alliance Bernstein, among others. This shortfall has spanned market capitalization and geography, engulfing small to large companies throughout developed and emerging markets around the globe. While there are no apparent signals to indicate if or when the relative performance trend may reverse, investors should be aware that such reversals often happen very abruptly and tend to act extreme. It’s difficult to accurately time a reversal, but relative valuation is often the reactant, and in some sectors, we are getting close to such extremes.
Moreover, to the extent there is higher inflation and a rising interest rate environment, some commodity companies could become relatively more attractive, for the first time in a long while. Over very long periods of time, value stocks historically have outperformed growth stock, but the relative performance tends to be somewhat cyclical, raising the question of the timing of a reversal. Concerning growth investing, the growth style’s dominance since the global financial crisis a decade ago has been particularly propelled by a narrow group of technology titans, the so-called FAANG stocks (Facebook, Apple, Amazon, Netflix and Alphabet’s Google). For many big tech companies, profit margins and cash flows are at, or near, all-time highs, so their relative valuations don’t appear to be extreme, particularly after the recent downturn in their stock prices, and if you look at relative valuation based on sales, the valuation would be considered below average.
We should note that we are in uncharted territory in terms of how these huge tech companies and other high-growth companies will perform in a changing economic environment, Google and Facebook, for example, are very ad-centric, and there are no pervious cycles where such dominant companies had to adapt to a more sluggish economy that could undermine ad revenues. This would state the case for the revival of value investing in the future, since other industries have been operating for more than a hundred years and have shown to adapt well when the economy changed course.
The long period of low interest rates is another cause for the increased attractiveness of longer duration assets, i.e. growth investing, according to Inigo Fraser-Jenkins, Bernstein’s head of European quantitative strategy. The Federal Reserve started its quantitative easing program to salvage the economy from the 2008 recession, but at the same time, an easier monetary policy lifted valuations across the board, leaving a smaller premium on cheap stocks, hence the long stretch of underperformance of value names. Take iShares S&P 500 Value ETF for example, an exchange traded fund that tracks the undervalued stocks in the S&P 500. It has been consistently lagging the market in the last five years.
In short, the definition of value investing in today’s robust economy still means remaining patient and investing for the long-term. When the market resets itself or makes an untimely dip, solid companies can suffer stock declines and long-term investors can earn excellent value. Currently growth investing is the dominant strategy, however, a hundred years’ worth of data says value investing works, and one cycle, however odd or peculiar, doesn’t change that.
Written by Sebastian Cornielje