Overview
The logic of ‘value’ investing has always sounded strong. Intuitively, it makes sense: pick companies that are well run, with a strong business model, but currently priced below their long-term potential, and somewhere down the line you should be able to realise their fair value. The last decade has punched a hole in that proposition, if not the logic behind it, as investors massively prioritised ‘growth’ stories over value in an environment of ultra-cheap leverage. But last year looked like a turning point in that story - and an examination of previous decades suggests it might indeed have been one.
This week’s Chart Room shows that value plays have outperformed growth ideas in every decade bar two since the 1930s, through varying growth, interest rate and inflation environments. The chart looks at US stock performance by decade from 1930-2020, showing that the stocks with the lowest price-to-book (PB) ratios earned 5.22 per cent more per year, on average, than stocks with the highest PB ratios. The exceptions were the 2010s with their ultralow rates, and the ‘dotcom boom’ era of the 1990s.
Periods of outperformance of growth stocks tend to be associated with the emergence of big, new, unexpected drivers of growth. As these growth drivers emerged, it became clear which companies would benefit and those companies started outperforming. Once the growth drivers became well understood, speculation took over and the growth stocks started to be rerated at a wild premium to the market, which on a valuation basis was not justified by their future growth potential. So, for example, we can say for illustration that 2007 to 2015 was characterised by genuine growth outperformance, but from 2016 to 2020 we saw more speculative outperformance. We saw similar market behaviour during the decade from 1990-1999.
Each growth cycle then, of course, delivers a third phase where reality sets in and a return to something resembling fair value ensues. During previous periods of NASDAQ outperformance, this third phase lasted 5-6 years, which has typically been the time it took the market to absorb changing fundamentals in old growth drivers and for new growth drivers to emerge.
It’s important to emphasise the above timelines are purely illustrative based on past market performance. But all of this of course chimes well with Business 101: new businesses emerge, they develop, they capture a dynamically expanding market before settling in to cash-cow mode, whereupon more competition arrives and their first-mover edge evaporates. Looking at streaming, or cloud services, or social networking, you might well think there is a lot of new competition homing in on many of the big corporate success stories of the past decade. And no doubt we’re searching for the next drivers of growth, be it AI, green tech or the metaverse, to name a few current candidates.
In the meantime, in a market where all boats have ceased to rise, investors may once again find themselves focusing on value ideas that are driven not by macro variables like interest rates, but by fundamental analysis. That analysis gains you a deeper understanding of the businesses you’re investing in and the long-term tailwinds supporting industries. But it is also based on some ‘common sense’ understandings: that quality businesses trading below their intrinsic value are attractive both to companies looking to grow through M&A, and to private equity or value investors within asset managers.
It is, after all, the same logic we tend to follow in our daily lives: you would never buy a house without thinking about its fair value. Strive, indeed, to buy any asset at a discount - a discount to its fair value.
