Wednesday, November 4th, 2020
“Values Continued Underperformance: What’s Up With That?”
Given that the past few weeks have been filled with non-stop political ads across any medium that the various campaigns can reach people, I thought I'd discuss something completely unrelated to anything political - the value vs. growth stock dynamic.
To give a loose, non-academic recap, companies that fit the definition of growth stocks are those that have higher stock prices relative to some fundamental metric (i.e. sales or profits), due to investor's willingness to pay a premium now to reap the benefits of high future growth. Value companies, on the contrary, are those whose stock prices are low relative to their fundamentals. Value investors buy these stocks with the expectation that the market will properly recognize the company's value and the price will converge up towards that value.
For over a decade, growth stocks have meaningfully outperformed their value counterparts. It is easy to see why investors were more likely to pay up for growth rather than shift towards value, as the story for growth stocks has been one of superior profitability and low-interest rates, sending these stocks roaring higher. Additionally, with the economy and market trending upwards and quite some time since the last recession, investors likely had an easier time justifying high valuations, while bear case scenarios were seemingly less likely.
However, over the history of the stock market, value has tended to outperform growth over full market cycles - largely due to outperformance during bear markets and over the full cycle of recession recovery. Unsurprisingly, this led to many investors being flustered by growth's 26%+ outperformance since the market's February peak. Digging into historical data may help answer why this happened.
We can categorize the past 6 bear markets by 2 catalysts: a shock to fundamentals (i.e. Vietnam War & Iran Oil Crisis) and the popping of a bubble (Nifty Fifty & tech bubble). When preceded by a bubble (defined as a wide value-growth valuation difference), value strongly outperforms both in bear markets and over the full cycle of the recession/recovery. However, when the catalyst is a shock to fundamentals, value tends to perform poorly.
Source: Research Affiliates, LLC
This makes intuitive sense. With a bubble, irrational market sentiment pushes prices of growth stocks too high, while value falls out of favor - so the bubble bursting would lead to mean reversion and value outperforming the market. When it is a shock to fundamentals, value stocks get punished more because they tend to exhibit weaker growth prospects and more areas of distress, among other risky traits in the face of uncertainty that leads the market to command a lower price.
Yet, as the market gains clarity about the future, it begins to recover and recessionary fears ease, the excess risk that is priced into value stocks subsides, and investors are rewarded. If you take values performance in the subsequent two years following the trough of each of the 6 bear markets, value outperforms the market by a whopping average of ~24%.
To give an example, the collapse of several financial institutions in 2008 led to a fear of a broader financial collapse, sending the stocks of cyclical companies and those that relied on credit tumbling the worst. This makes sense, these stocks were scary to hold, but when it became clear that the financial sector would withstand the shocks, these companies' valuations recovered and the investors brave enough to buy and hold these companies were handsomely rewarded.
It is clear that Covid was a shock to fundamentals, but the value-growth valuation difference was also one of the largest it has ever been prior to the downturn. That gap grew to what many categorize as the all-time peak after the downturn, signaling the market remains in a bubble. The only other time that both a bubble and a shock to fundamentals were present in a bear market in the post WWII economy was the Nifty Fifty/Oil Crisis, which led to ~31% of outperformance in the subsequent two-years. Should this bubble burst and the valuation gap narrow, investors of these companies would realize an attractive return.
Importantly, not all recessions are created equal and, therefore, value stocks perform differently in different downturns. So although historical data of economic downturns is helpful, it is still a small sample size and certainly has many limitations in extrapolating out what will happen going forward. Additionally, growth investors have put out excellent, convincing defenses as to why growth can continue to outperform value.
With that, we remain steadfast learners who continuously look to improve our understanding of the markets in order to build portfolios that best help our clients meet their long-term goals. However, our belief in the importance of remaining diversified and balanced so that our portfolios can withstand the test of time is one thing we are happy to keep constant.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which Investment(s) may be appropriate for you, consult your financial advisor prior to investing. Information is based on sources believed to be reliable, however, their accuracy or completeness cannot be guaranteed. Statements of forecast and trends are for informational purposes and are not guaranteed to occur in the future.
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