This is a series focused on recent developments in the financial markets. The aim is not to discuss the latest news. Instead, we’ll focus on emerging long-term trends and lasting lessons to learn from recent events. It will also take recent developments as examples that can teach us more about markets and investments.
Is value investing making a comeback?
Investors trying to choose a strategy soon stumble upon the debate between growth and value investing. Growth investors target high-growth companies, which typically operate in a rapidly changing environment and rely heavily on innovation. Value investors focus on buying stocks that are currently being sold at a price below their intrinsic value (large margin of safety).
Value has outperformed growth for a decade. That often happens during a bull market, but the bull market seems to be over. The recent decline in growth stocks suggests it may be time to rethink the growth versus value discussion.
The debate on growth versus value
Typical descriptions of investment styles can become caricatures. Growth investors don’t all mindlessly ignore valuations. Many value investors include growth in their calculations.
However, there are significant differences between the 2 strategies, and the psychological profiles of each type of investor differ. Growth investors tend to be more focused on the future and opportunities. Value investors tend to focus on risk management and not losing money (Buffet rule number 1).
These differences have led to the creation of special funds focused on ‘growth’ or ‘value’. Historically, value was believed to outperform growth over a long enough period of time. But since 2008, that is no longer the case. And the discrepancy became even more spectacular after 2018 and the explosion in the share price of growth stocks like Tesla.
14 years is a long time to underperform, and many people were skeptical about value investing as a result. In fact, I’d say the consensus was that value is out of fashion, obsolete, and downright dead.
Grow in trouble
A performance shift took place in the period from 2019 to 2020. No fund has been more symbolic of its focus on unprofitable growth and technical enthusiasm (mania?) than the ARKK ETF, led by Cathie Wood.
In 2021, ARKK’s value has more than doubled in just 2 years after an already impressive performance in previous years. Yet ARKK’s fate has drastically reversed. The year-to-date performance (and we’re just into April) is -46%.
What’s worrying is that the ARKK pattern almost perfectly mimics the last massive surge in Nasdaq during the dotcom bubble, before an equally massive crash. The similarity between the two graphs is uncanny.
What brings ARKK down is a broad decline in technology stocks. Most vulnerable are stocks with very high valuations compared to current earnings/revenues. Markets have high growth expectations for these stocks. Any sign of trouble is brutally punished.
Most notably, Netflix crashed -34% of its rating in one day when it announced a slowdown in user growth. Compared to its October 2021 peak at $690, Netflix stock has lost 72% of its value. That decline was not caused by catastrophic news, but only by fears of slowing growth.
The same panic gripped most technology stocks that day, with an average loss of 10%.
The Netflix crash illustrates the problems with some growth strategies. Expected growth is used to justify increasingly higher multiples in ratios such as price/sales, price/earnings or enterprise value to EBITDA. No ratio is too high if the company has network effects and continues to grow
The valuation of Netflix’s stock – with a price-to-earnings ratio of 253 and a price-to-sale ratio of 13.3 – reflected expectations of perfect growth and results for eternity. What has happened recently is not that the Netflix company is in big trouble per se. But NFLX’s stock is being repriced at more reasonable and much lower ratios.
These kinds of multiple contractions can do massive damage to high-flying stocks, even if they’re still growing. Just the hint of a slowdown in growth may be enough to send stock prices into a nosedive.
The Tortoise and the Hare
It is definitely too early for value investors to claim victory after a 14-year period of underperformance. But personally, I think both methods seem valid at the very least, contrary to claims that value has been left for dead.
To support this view, I will use a price chart comparing 2 emblematic companies, Berkshire Hathaway (BRK) as the archetypal value investing ‘fund’ versus ARK Invest (ARKK) as the archetypal ‘new era’ growth fund.
Since 2017, Berkshire has performed under ARK. This became even more dramatic in the age of everything at a distance due to the pandemic. Still, Berkshire, the tortoise could beat the ARK hare in that race, while ARK has lost all of its advances in the last few months.
Value investing has a reputation for being a bit boring, slow and numbers focused. These comments are quite right. I also think that as a society we need to fund innovation and take risks to move forward. I don’t feel like denigrating growth investors or being dogmatic about the superiority of value investing.
Growth investors have a reputation for being over-enthusiastic and taking big risks. I think they need to look at the past few months and question their assumptions. P/E ratios of 100 or more are always at risk of price revision, no matter how high the quality or the rapid growth of the company.
Appreciation doesn’t matter until it does. Maybe it’s not just that “dear guys don’t get it”. While growth investments in periods of expansion are likely to outperform, gains driven by excessive enthusiasm are likely to disappear as market momentum reverses and investors become more conservative.
Humility is an investor’s greatest asset. It allows us to look honestly at our mistakes and prejudices. To set course and keep learning.
In that vein, the recent difficulties facing growth investors should prompt them to take a more cautious approach. And the recent comeback of value investors should not be a reason to brag or mindlessly claim that their method is the best. Market wins are erratic and arrogance is quickly punished!
This post Is value investing making a comeback?
was original published at “https://finmasters.com/value-investing-comeback/”