Value Beats Growth

All that glitters isn’t gold … it’s true. Of late, it seems investors may have forgotten that important lesson. Specifically, investors have fallen in love (again) with growth stocks. There are a numbers of ways to define “growth stocks.” The most common would be that a growth stock is the stock of a company that is experiencing a high rate of sales growth or earnings growth. Some growth stocks don’t have earnings but are expected to have great prospects for earnings in the future. Perhaps the best way to define growth stock is to say Facebook, Tesla, Netflix, Apple, Google, Gilead Sciences and Amazon. That helps doesn’t it? Critical to understanding growth investing is to understand that growth stocks usually trade at very high prices … high multiples of earnings or sales. This is because investors have lofty expectations that these companies will rapidly grow their earnings, thus justifying the higher valuations. For example, Amazon today trades at 92 times next years expected earnings, Netflix trades at 250 times its earnings of the last 12 months and Tesla, the electric car and battery maker is valued at $31 billion dollars despite never turning a profit. In contrast to these growth stocks, “value stocks” typically trade at much lower valuations. For example, slow-growing IBM trades at 9 times next year’s expected earnings, Wells Fargo trades for 12 times earnings and Exxon trades at 17 times earnings.

I read an article in the Wall Street Journal about six weeks ago that noted that just six growth stocks accounted for substantially all of the gain in the S&P 500 in 2015 through the end of July. Five of the six are listed above and Disney is the sixth. As of this writing, the S&P 500 no longer has a gain this year but the point remains that a concentrated number of stocks have experienced gains this year while the majority of companies are lagging. We last saw this phenomenon back in 1998, 1999 and early 2000 … the dot.com, tech bubble years. At the time, the majority of companies saw their stock prices stagnate or decline while a handful of large technology firms powered the market indices higher. I remember all too well when clients called to ask, “Why does Bragg own these ‘old-economy, value’ stocks in the portfolio? The companies of the future seem to be the “new-economy, growth” firms like: AOL, WorldCom, Sun Microsystems, Intel, Cisco, Microsoft, EMC, Oracle and DELL. Shouldn’t we buy more of these?”

The questions started sounding more like demands in 1999 when the tech-heavy NASDAQ soared over 85% in a single year. It seemed investors couldn’t resist chasing after these returns. It is hard to believe it has been more than fifteen years since we endured that difficult period. Maybe fifteen years is just long enough for investors to forget the pain they endured when the technology party ended. If you’re in the forgetful camp, take a look at the table below.

Growth dominated Value as the tech bubble inflated. This did not end well.

Large Growth Returns: Average of Dow Jones Large Growth Index and Dow Jones US Large Cap Growth Index.
Large Value Returns: Average of Dow Jones Large Value Index and Dow Jones US Large Cap Value Index.
Small Growth Returns: Average of Dow Jones Small Growth Index and Dow Jones U.S. Small Cap Growth Index.
Small Value Returns: Average of Dow Jones Small Value Index and Dow Jones U.S. Small Cap Value Index.

And take a look at the recent performance of growth and value below. A significant gap has opened up between growth and value. While both are negative, value has fared much worse than growth.

We’ve Recently Seen a Gap Opening between Growth and Value

Large Growth Returns: Russell 1000 Growth.
Large Value Returns: Russell 1000 Large Value.
Small Growth Returns: Russell 2000 Growth.
Small Value Returns: Russell 2000 Value. Past performance is no guarantee of future performance.

Why is this happening? It may be because investors are getting it right. Maybe Amazon, Facebook, Tesla and Netflix will grow into their lofty prices and therefore deserve to be driven up to these high levels. Or maybe investors are simply gobbling up the only growth they can find. And growth is not abundant these days. Many US corporations have seen their earnings growth slow dramatically or even decline over the last 12 months in the face of a stronger dollar and a slowing global economy. The few companies enjoying continuing growth are attracting a lot of attention. Finally there is the “rearview mirror effect” that leads investors to chase what has been hot. We’re likely seeing a combination of these factors at play. Regardless of the reasons why the gap has opened between growth and value, our job is to stick with the discipline of owning a diversified portfolio.

Bragg’s portfolio has historically had a “tilt” toward value stocks. Said another way, we’ve made an effort to construct a portfolio that we believe is more defensive than the market. The goal is to preserve capital in down markets while knowing that in hot growth markets, we may trail the major benchmarks. While there is certainly no guarantee that we’ll accomplish this, over full market cycles we hope to perform in line with the market while taking less risk. My father always said, “we think we’ll lose less money than the other guys who are out there trying to shoot the lights out.” While this likely sounds attractive on its face, history makes the case that investors who followed this approach over the long term fared very well compared to a growth strategy. Spend some time studying the table below which compares growth and value indices from 1980 through today. In particular, look at the ending value of $10,000 invested over this period assuming one earned the index returns. I think you’ll agree, the difference is dramatic. This is why we emphasize value in our portfolios.

We’ve Recently Seen a Gap Opening between Growth and Value

Through 2010: Average of Dow Jones Large Growth Index and Dow Jones U.S. Large Cap Growth Index. After 2010, Russell 1000 Growth used.
Through 2010: Average of Dow Jones Large Value Index and Dow Jones U.S. Large Cap Value Index. After 2010, Russell 1000 Value used.
Through 2010: Average of Dow Jones Small Growth Index and Dow Jones U.S. Small Cap Growth Index. After 2010, Russell 2000 Growth used.
Through 2010: Average of Dow Jones Small Value Index and Dow Jones U.S. Small Cap Value Index. After 2010, Russell 2000 Value used.
Past performance is no guarantee of future performance.

Past performance is no guarantee of future performance. Investors can not invest directly in an index. Opinions expressed here may change.