The Growth vs Value Debate
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The above left chart is often used to argue that growth is excessively stretched vs value. Some argue this is more extreme than during the dot-com bubble of 2000. We believe this view is misguided for several reasons. Firstly, value stocks have significantly higher dividend pay-out ratios, so at the very least the chart should be adjusted to total return (above right). This reduces the outperformance for growth over the nearly 25 year period from 76% to a less significant 27%. However just looking at historical price performance and expecting a mean reversion seems naive. A more informed view has to consider some of the drivers of price.
Bringing earnings into focus.
In the long run earnings drive price, and looking at the above charts the growth index trades at a current p/e ratio premium of around 67.5% and an estimated premium (next 4Q) of 49%. These are reasonably close to the 25 year average of 46% and 35%, and way below the dizzy heights of around 350% and 270% during the dot-com bubble peak of 2000.
Return on common equity.
The above charts show one of the quality factors we monitor- Return on Equity. As we can see the growth sector has experienced a growing and more stable ROE profile, and is at a much higher rate. (Currently 29.2% vs 6.3%) While the value sector has been on a more volatile and cyclical downward path. Given this backdrop maybe the 14% premium for growth over value’s 25 year average Est P/E ratio is warranted.
What about academic research suggesting long run value factor outperformance? Again, one has to dig deeper and look into the current index and identify the drivers. The main difference in sector weightings is that the Value index is dominated by Financial and Energy stocks. The macro environment for these two sectors has been very poor. Zero rates, flat yield curves, higher regulation and less leverage have adversely affected the Financial sector performance. While a global push for renewables is providing negative headwinds for the Energy sector. It is hard to argue that these themes will change in the short run. Clearly these macro factors explain a lot of the value underperformance which a one dimensional price chart cannot. Conversely growth now has a lower discount factor for future cash flows, and has experienced a lockdown boost to demand. One can see that these may dissipate somewhat next year. However considerations such as accounting practices for intangibles and share repurchases have also likely altered the constituents of the respective indexes over time and make a strong view more difficult.
Our view is that we don’t think the current growth/value spread is anything like the historical extremes of 2000. In fact, when looking at the significant benefits of growth over value, earnings multiples and the macro drivers over the post 2008 period, we think the spread is probably closer to fair value than overvalued.
However, regardless of the future path, at Nutshell we prefer a bottom up approach and will invest where we think the best long run risk adjusted return lies. We are flexible and not pigeonholed to value or growth. We invest in a concentrated portfolio of exceptional companies at reasonable valuations. Companies which already have a proven track record, wide moat and offer “value” given their individual set of favourable characteristics. (Interestingly our bottom up approach has led to a recent increased exposure to the Technology sector, with Tencent and Qualys entering our Top 10). 2021 is likely to be characterised with a continued tussle and debate between growth and value. We prefer to stay focused on holding quality companies at reasonable valuations, rather than a top down macro allocation to either value or growth.
The Case for Long Run
The above chart shows the compelling evidence for equity investment. $10 invested in the S&P500 in the 1930’s would have grown to around $80,000 today. The period covers the depression, WW2, 87 crash, the dotcom bubble, and the financial crises to name a few.
What the top right chart shows in log space, is that long run equity returns are relatively consistent. (The average annual return being 11.4 %*) Excluding the depression which one can argue was created by policy mistakes** this then rises to 12.7% and regardless of which event/crisis, there is a mean reversion to this trend. Despite the continual bearish commentary for virtually the entirety of my career recent performance doesn’t seem to be out of line.
Over shorter holding periods, returns are noisy as events and economic cycles dominate. Bear markets and “irrational exuberance” come and go. Bad periods tend to lead to good periods e.g. the 12 months to July 1933 and March 2009. (If you follow our argument outlined in March research: Vol as a driver of future returns, the 12-month period from March 2020-March 2021 is in our opinion, likely to produce another positive spike)
What is striking is that over long holding periods such as 25 years, (suitable for pension, ISA and Child Trust funds) average returns are stable. Generally speaking, any 25-year period over the last 100 years would have produced an average annual return of between 10 and 16%. The lowest point being the 25 years to the early 80’s which covered the stagflation of the 1970’s prior to the Reagan and Thatcher reforms. This subsequently led to the strongest 25-year period around the end of the Tech Bubble in 2000.
This month is my 25th anniversary of graduating from LSE and starting a city career. Even this period from 1995 covered the Tech Bubble/bust, and the 2008 financial crisis (i.e. a decade of zero returns) has managed an average annual return of 11% pa. Back then the world was a hugely different place. London property was trading at around 2.5 x first time buyer earnings and 10-year gilts were yielding 8%. There were lots of options as an investor. Today with London property trading around x10 first time buyer earnings and 10-year gilts recently hitting sub 10bp, there is a scarcity of sensible options for investors. Hopefully, this article will show that the case for long term equity investment is as clear as ever, and relative to alternatives, very compelling.
At Nutshell we also aim to further reduce the volatility over shorter holding periods through robust stock selection and our recession indicator. We also monitor the relative value of equity vs bonds and adjust the equity beta accordingly. We invest in a small selection of exceptional companies which typically perform well during stressed environments.
* Federal Reserve Bank of San Francisco “The Rate of Return on Everything, 1870-2015” went back even further and found a total average annual return of 11.08% over a 143-year period. Increasing post 1950 and 1980)
**Remarks by Governor Ben S.Bernake Nov 8 2002. Commenting on Milton Friedman and Anna Schwartz’s study of the Depression. “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” (Which was true, as shown in 2008 and 2020)