By Charles Pohl
One of the enduring debates in equity investing has been between those investors who emphasise “value” and those who emphasise “growth”. While analysis of historical data shows value stocks have outperformed growth stocks over extended periods in the last 90 years, the past decade (2005-15) has been one of the few periods when value has lagged growth.
This trend has been particularly noticeable in the United States with the Russell 1000 Growth Index having a 5.7% total return, nine percentage points ahead of the Russell 1000 Value Index in 2015.
This is not to say however that the current status quo will remain and, indeed, if one looks at the ways in which markets have historically responded to fundamental value, there is reason to believe the current divergence could narrow or even reverse.
At the beginning of 2016, growth equity valuations had become more expensive than at any time since the technology stock bubble, while value languished. As a result, the valuation differential was significantly wider than typical. Yet historically, returns for value-focused strategies have been closely related to valuation spreads, with stocks that are relatively cheap offering a greater potential for higher returns. In other words, the more undervalued a stock is, the more it may potentially appreciate as its share price moves to reflect intrinsic value.
Data based on a price-to-book (P/B) valuations shows value stocks today are trading at significant discounts relative to historical norms. Indeed, sizeable valuation disparities have arisen between the growth and value segments of the market as investors have favoured stocks with strong expected growth prospects, subsequently driving the price of high valuation stocks even higher. The “FANG” stocks (Facebook, Amazon, Netflix, Google) are a good example of this, gaining $450bn of market cap during 2015; however, their combined earnings only rose by 21%.
The wide gap that has opened up between the valuation of growth stocks and value stocks presents value investors with real opportunities. The market may not immediately respond to the intrinsic value of these companies as measured by sales, cash flow, earnings, or book value multiples, but over time market prices tend to move towards fundamental value.
Of course, every stock whose price has been knocked down is not a value opportunity. In a number of cases investors have correctly responded to diminishing opportunities resulting from faltering markets, inadequate products and services, or discernible weaknesses in management and governance. Because of this, it is important for value investors to test and retest their investment hypotheses when searching for bargains.
All of this being said, such opportunities generally only come to fruition for those who are patient. All too many investors move in and out of investments at the wrong time: the jump into individual issues or funds at what turns out to be the end of a period of good performance, and rush out after a period of poor returns only to find they have sold at the bottom.
Chasing past returns in this fashion ends up hurting long-term investment results because it is exceedingly difficult to pinpoint turns in the market; indeed, just being in or out of a market for the few days in which dramatic movements occur can have a sizeable impact on longer term performance. It is therefore particularly important for a value investor to remain patient in times of market volatility.
Charles Pohl is chairman and chief investment officer at Dodge & Cox
