QUOTE OF THE WEEK
"I'm convinced that there is much inefficiency in the market... When the price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical."
– Enjoy more of our favorite investing-related quotes –
May 29, 2017
THE COMING RALLY IN VALUE STOCKS
Value stocks have lagged growth stocks since late 2016. However, the principle of mean reversion suggest that this imbalance should soon reverse and value stocks will soon surge higher to reclaim their historical status as the clear leader in this contest.
GROWTH IS OUTPERFORMING VALUE
Since the end of 2016, Growth stocks have out-performed Value stocks, which conventional wisdom tells us is unusual. To analyze the possible reasons for this behavior, we reviewed the historical literature that examined the performance of Growth Stocks compared to Value Stocks. We also provide an in-depth analysis of which approach to investing has been most productive in the last two decades – a time when valuations have been much higher than their average over the prior eight decades. Our goal is to determine what outcomes investors can expect in the coming weeks and months from both Growth stocks and Value stocks.
Chart 1 below shows a comparison the iShares S&P 500 Growth ETF (IVW in green) versus the iShares S&P 500 Value ETF (IVE in red). We can clearly see that Growth stocks have maintained a steady upward trajectory, while Value stocks have moved sideways since last December.
Chart 1: In the last 6-1/2 months, growth stocks have significantly outperformed value stocks at a pace of about 10% annualized. While growth stocks have steadily climbed following the November 2016 election, value stocks have flatlined for 5-1/2 months.
Following last November's election, value stocks outpaced growth stocks briefly before flatlining (with a brief February surge) for 5-1/2 months, from December through Mid-may. In early 2017, growth stocks overtook value stocks and now have a 5.4% performance advantage since last November. Will the principle of mean reversion change that status and soon propel value stocks past growth stocks? We will analyze the prospects of that outcome in this week's Intelligent Value Alert newsletter.
TWO TYPES OF INVESTORS
There are many approaches to investing, but the vast majority of investors fall into two philosophical camps that tend to align with the person's temperament, risk tolerance, and time frame for results.
1) The first group of investors includes those who are attracted to companies that are making headlines, get frequent mention on business TV and in print, and have strong forward performance expectations. These high-flying companies attract fast-paced GROWTH investors, whose focus is on expectations of the future.These investors believe that if they can identify a business that will grow at a faster pace than average, the return on their investment will likely be proportionally higher than average.
Growth investing gets the most attention on television, with one after another 'expert' appearing on channels like CNBC to tout their favorite stock of the week (or day or hour, it often seems). Traditional news sources and hundreds of internet websites traffic in a constant flow of the most exciting tidbits of information. All the major brokerage houses have refined their business models to cater to an up-to-the-second-quote, push-button, rapid-fire style of investing. This investment approach depends on forecasts of the future to satiate growth investor's thirst to know what will happen. All the big brokerage houses oblige with a constant flow of earnings forecasts, which conveniently manufactures demand for their product, the trading of equities.
2) The second type of investor is interested in buying a stock when it is a bargain, with a price that is low relative to fundamentals such as revenues, earnings, book value, or enterprise value. A stock selling at a discount to a company's fundamentals attracts VALUE investors who focus on present conditions. Value investors believe that if you buy a stock when it is selling at a significant discount to the fundamental value of the company, the market will inevitably correct that mispricing and the investor will reap a substantial reward from the arbitrage between price and value.
Both of these styles of investing are logically sound and can be quite profitable. Advocates of each approach can cite success stories of individuals who became quite wealthy while exclusively using either style. On the other hand, each type of investing also has inherent drawbacks and can result in significant losses if the investor is not attentive to these Achilles heels.
GROWTH INVESTING WEAKNESSES
While growth stocks can have a more near-term payoff, they are usually more expensive (because their price often already discounts the high future expectations of other investors). Since speculation about the future determines much of the price of their stock, any news having to do with earnings or growth has the potential to create a surge of investment profits or dramatic portfolio losses. When growth-stock investors become disenchanted with a company, they frequently move like lemmings, abandoning the stock en masse and proceed to the next exciting company. Those slow to pull the trigger on a sell order after disappointing news can suffer significant losses during the rush to the exits, so growth investors must be extremely attentive to news and prepared to respond rapidly.
VALUE INVESTING WEAKNESSES
Alternatively, assuming a company's cash flows are steady (to avoid value traps), most value investors believe their stocks are inherently safer because the purchase price comes at a discount to the company's liquidation value, book value, or other substantive fundamental criteria. This approach involves no speculation about the future. Nevertheless, unless a near-term catalyst is imminent, the time required for an undervalued stock to attain full value can pose the greatest challenge. Many individuals get frustrated when their money is tied up for lengthy periods of time while they watch others profiting from alternative opportunities. For this reason, many would-be value investors give up too soon on a stock, selling early when more disciplined patience might have amply rewarded them.
APPROPRIATE FOR YOU?
The Value-investing approach demands and rewards in-depth analysis and disciplined patience while the Growth-investing approach requires constant attention and cat-like reflexes to respond to the endless flow of earnings-related and other corporate news. Most value investors will agree that static factors describe their style while most growth investors might more reluctantly recognize that dynamic elements underscore their approach. Temperament plays a prominent role in determining to which investment style an individual is attracted.
WHICH APPROACH IS MOST PROFITABLE?
For many decades, Ibbotson Associates, Inc., a research-based investment service that is now part of the Morningstar Investment Management division, has published annual studies that compare value stocks to growth stocks over extensive periods of time. These studies were historically the most comprehensive ones available, with Ibbotson's data beginning in the 1920s. The firm's results have consistently shown that value stocks beat growth stocks by a significant margin.
Chart 2 below shows an Ibbotson study run on data from 1927 to 2012 with Large-cap Value stocks compared to Large-cap Growth stocks. Ibbotson determined that Large-cap Growth stocks produced an annual return of 9.0% while Large-cap Value stocks generated an annual return of 13.0% (a 44% outperformance) during this period.
Chart 2: Ibbotson Associates found that from 1927 to 2012, large-cap value beat large-cap growth by an annual return of 13.0% to 9.0%.
Chart 3 below shows the same time period (1927–2012) using small-capitalization stocks. The outperformance with small companies was more drastic; Small-cap Growth stocks generated an annual return of just 8.1% while Small-cap Value stocks produced an annual return of 18.9% (133% outperformance).
Chart 3: Ibbotson Associates found that small-cap value stocks beat small-cap growth stocks by 18.9% to 8.1% annualized from 1927 to 2012.
In addition to the annual studies from Ibbotson Associates, dozens of academic researchers (including the famous 'French/Fama 3-Factor Model') seemed to have conclusively determined that value stocks consistently outperform growth stocks.
GOOD VALUE VS BAD VALUE
So is the case closed on the superiority of value stocks over growth stocks? Not so fast! Let's briefly review the theoretical foundation of stock pricing and how value became recognized as a durable anomaly of the Efficient Market Hypothesis (EMH).
In 1965, the Efficient Market Hypothesis was a PhD thesis published by Professor Eugene Fama. He argued that stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can obtain higher returns is by chance or by purchasing riskier investments.
EMH, and its successor, the Capital Asset Pricing Model (CAPM), met with criticism from successful investors who pointed out that small-cap stocks consistently outperformed large, and undervalued stocks consistently outperformed the market. In response to EMH and CAPM, Warren Buffett published a wonderfully inspiring essay titled, The Superinvestors of Graham and Doddville, which pointed out the long track record of success from value investors who used the principles of Benjamin Graham, known as the "Father of value investing." Needless to say, Buffett has a 60+ year track record of consistent outperformance of the market and the status of the wealthiest investor of all time to back up his position.
There are no undervalued stocks, these theorists argue, because there are smart security analysts who utilize all available information to insure unfailingly appropriate prices."
– Warren Bufffett, The Superinvestors of Graham and Doddville
In response to these criticisms of EMH and CAPM, Eugene Fama and Kenneth French of the University of Chicago created their famous Three Factor Model as an alternative that would explain the systematic anomalies of company size and valuation that endlessly aggravated Efficient Market proponents. Fama and French retained risk (which they defined as volatility), but added size (SMB, or Small market-cap Minus Big market-cap) and value over growth (HML, or High book-value-to-market-cap Minus Low book-value-to-market-cap). French and Fama went on to prove that small-cap stocks indeed consistently beat large-cap stocks and undervalued (high book value relative to market-cap) stocks consistently outperformed the market.
Let's stop and focus on that definition of that value anomaly: High minus Low (HML) book value, also referred to as the value premium, which accounts for the spread in returns between 'value' and 'growth' stocks and argues that companies with High book-value-to-market ratios or "value stocks," outperform companies with Low book-value-to-market ratios or "growth stocks."
Most finance academics remain steadfastly confident that they are correct in the above definition of growth and value and are still publishing studies on the "value anomaly" as identified above. Also, private companies like Ibbotson Associates and Morningstar are still using that definition when releasing their annual report comparing the performance of Value vs. Growth stocks.
So what's the problem? These ivory-tower eggheads, the vast majority of whom have never purchased a single share ofpublicly traded equity in their lives, somehow still believe that low book-to-market (aka, expensive) ratios identify growth companies. While it is generally (although not necessarily) true that growth stocks are more expensive than value stocks, the way to define growth stocks has little to do with having a Low Book-to-Market Ratio. In fact, most contemporary growth stocks consist of technology-related industries such as IT and biotechnology, which require a relatively small investment in capital assets (which go on the "Assets" side of the Balance Sheet statement). What a Low Book-to-Market Ratio defines is BAD VALUE!
Most readers would probably agree with us that the long-standing 'Low Book-to-Market' definition used by academics and financial establishment folks to define growth stocks is inappropriate, and it would be preferable to use different criteria. Also, measuring the degree a company is 'undervalued' should not rely on the single factor of relative Book Value. Also, for several reasons, stocks seem to have entered a new paradigm of valuation, and the old CAPM definitions from the 1960s-1990s no longer seem applicable. With globalization becoming pervasive, American companies no longer need vast manufacturing plants or other production facilities/equipment, which create a sizable Book Value. Companies now offshore much of that work to inexpensive manufaturing countries like China and India. As a result, the Book Values of American companies are much lower today than they were in past decades.
Also, since the late 1990s, valuation ratios are significantly higher than their historical average. According to Jeremy Grantham of GMO Capital, from 1920-1997 the average Price/Earnings (P/E) ratio of the S&P 500 was 13.95. However, for the last two decades, from 1997 to present, the average P/E ratio of the S&P 500 is 23.36. Grantham believes the fundamental difference in P/E ratios between the last two decades and previous decades is that profit margins have expanded, partially as a result of globalization, technological innovations adding to productivity, and other historic changes.
For this rationale and more, we believe it is time for the academics to use more appropriate definitions of Value and Growth than merely Good Price-to-Book ratio and Bad Price-to-Book ratio.
NEW DEFINITIONS OF GROWTH AND VALUE
Rather than use the usual measure of Good Value stocks minus Bad Value stocks that is employed by academics and Ibbotson Associates, we propose ranking stocks according to more appropriate financial benchmarks. We will then run the backtests using the top qualifying five percent of companies in each group (rather than "good" minus "bad"). This approach will result in a more accurate measurement of performance. We will also run the backtests on a contemporary period that reflects the increase in overall valuations from the late-1990s to today, as well as utilize point-in-time databases that eliminate survivor bias and provide far more accurate results than raw data.
We could create much more elaborate ranking systems, but to avoid the appearance of cherry-picking optimal factors, we will keep the systems relatively unsophisticated and rely on five factors each that most investors should agree upon as reflective of "growth and "value." We will also exclude quarterly corporate reports (to avoid unnecessary noise in time series data) and instead use Trailing Twelve Months (TTM) or annual results.
GROWTH RANKING SYSTEM FACTORS
There are many ways to define growth companies, but most would probably concur that at a minimum, it should include factors such as a higher sales growth and higher earnings growth than average, both compared to the past as well as forecasts of the future. Therefore, we built our GROWTH Ranking System on the following factors:
• Sales Growth, Trailing Twelve Months (TTM) vs. Previous Twelve Months (%)
• EPS Growth, Trailing Twelve Months (TTM) vs. Previous Twelve Months (%)
• Current Fiscal Year's Estimated EPS Mean
• Next Fiscal Year's Estimated EPS Mean
VALUE RANKING SYSTEM FACTORS
Similarly, we can define undervalued stocks in a variety of ways, but few would argue that the definition of company value would need to include criteria based on the Stock Price compared to Sales, Earnings, Cash Flow, and Free Cash Flow. Because of the changes to contemporary corporate Book Values mentioned earlier, we will exclude it from this comparison. Also, most value investors tend to eschew earnings-related data because of the high potential for management manipulation, so we exclude the PE-ratio. Therefore, we built our VALUE Ranking System on the following factors:
• Enterprise Value/Ebitda(TTM)
• Price to Sales Ratio (TTM)
• Price to Cash Flow Ratio, (TTM)
• Price To Free Cash Flow Ratio (TTM)
• EV/Operating Income Before Depreciation (TTM)
We applied the above-ranking systems to Wall Street-caliber, point-in-time data provided by Compustat, CapitalIQ, and Standard & Poors through the Portfolio123 website. For our universe, and to eliminate stocks that are uninvestable, we utilized the S&P 1500 index as our universe. The S&P 1500 is a composite of the large-cap S&P 500, the mid-cap S&P 400, and the small-cap S&P 600. As of the date of this article, the largest company is Apple, Inc. (AAPL) with a market capitalization of about $800 billion and the smallest is Tailored Brands, Inc. (TLRD) with a market-cap of $502 million.
For the back-test, stocks were further required to be ranked in the top 5% of each from the Growth and Value rankings from the S&P 1500 universe to qualify. For example, if a stock went into the portfolio ranked at 95%-99.9% based on the ranking criteria discussed above, it would be removed from the portfolio if its rank dropped to 94.9% or less and it would be replaced by that week's highest ranked stock. We rebalanced the portfolios weekly and limited each portfolio to 10-stocks. The backtest ran from January 2, 1999 to May 27, 2017.
GROWTH STOCK PERFORMANCE
A 10-stock portfolio based on the Growth Ranking System outlined above with all stocks required to be ranked in the top 5% of the S&P 1500 universe resulted in the following performance statistics:
Growth Performance Chart, 1999-2017
VALUE STOCK PERFORMANCE
A 10-stock portfolio based on the Value Ranking System outlined above with all stocks required to be ranked in the top 5% of the S&P 1500 universe resulted in the following performance statistics:
Value Performance Chart, 1999-2017
After abandoning the embarrassing definitions used by academics of Value as "good-book-value" and Growth as "bad-book-value" to a more accurate representation of each group using more appropriate fundamental factors, Value Stocks still trounce Growth Stocks!
In our analysis, the Total Return of Value Stocks is almost seven times higher than Growth Stocks (5,822.74% to 836.61%) over the 18.5-year performance test, and the Annual Return of Value Stocks is nearly double that of Growth Stocks (24.84% to 12.93%). Therefore, Value stocks still retain the crown when compared over periods of many years in contemporary times.
If Value Stocks so handily trounce Growth Stocks, how can we explain the outperformance of Growth over Value in the last six months (shown in Chart 1 above)? We believe it is likely that much of the recent out-performance of growth companies is the result of speculation based on the much-discussed "Trump Rally." This election-based speculation swept investors like wildfire following the November 8, 2016 election with the realization that business-friendly Republicans would simultaneously control the Presidency, both houses of congress, and the Supreme Court.
President Trump campaigned on promises to roll back corporate taxes (which would immediately boost the bottom lines of publicly traded companies), an easing of business regulations across the board, and a $1 trillion infrastructure program, all of which could send the value of America's corporations to the stratosphere if implemented. Companies that are already growing would likely increase their bottom lines the most in this environment, investors reasoned. Hence, money-managers over-weighted investment in perceived growth companies over the last six months which sent growth-stock prices surging.
However, while the "Trump Rally" has been impressive (with the market gaining about 15% or $2.8 trillion since the election after being flat for the prior year), reality is beginning to set in. The White House has become bogged down in endless mini-crises and scandals that threaten to sabotage the rally. If it becomes clear at any time during the next two months (June and July) that the business-friendly agenda is threatened, then the rally will likely collapse.
Mean-reversion is the most powerful force in investing, and anytime a historical economic relationship gets overly biased in one direction or the other, mean-reversion forces will inevitably normalize those conditions. Capitalism always finds a way to fill any gaps and bring unbalanced dynamics back to equilibrium.
We believe that Value Stocks will return to their market-leading status in the near future. The robust performance of the positions in our model portfolios last week may be evidence that the resurgence of value stocks is already beginning. To wit, Amkor Technology, Inc. (AMKR) surged by 7.12%, Kulicke and Soffa Industries, Inc. (KLIC) gained 5.20%, while Ternium SA (TX) completed a run with an 11.78% performance!
OUR PLAN FOR THIS WEEK
We are selling one position in our Relative Value Portfolio and purchasing a replacement for it at tomorrow's opening. Members can view this week's portfolio updates from the Portfolio Section of the Member's Area.
Don't forget that if you are not a paid subscriber, you can access all our content (including Market Risk Analysis, all Intelligent Value Alert newsletters, our Portfolio selections and history, and Intelligent Stock Analysis) instantly with a free trial. If you have questions about this publication or our approach, please feel free to contact us.
Best Wishes for Another Week of Intelligent Value Investing,
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Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the subjects discussed, market environment, company or ETF SEC filings. Investors may wish to consult a qualified investment advisor. The information in this material was obtained from sources believed to be reliable, but were not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. Neither IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.