Over the last year or two, much of the narrative around U.S. stocks has focused on FAANG (Facebook, Apple, Amazon, Netflix, Google), along with a select few other high growth companies like Alibaba and Tesla. These high growth stocks have been in vogue mainly because of their recent high earnings growth and strong stock price appreciation. In fact, for the first nine months of 2017, the “FAANG five” high growth companies are responsible for over one-third of the total return of the S&P 500, meaning the other 495 companies together represent the other two-thirds of performance. Describing the returns this year as being narrow is an understatement.
Although Growth and Value stocks may rise and fall in the same direction generally, history shows the two types of stocks experience long cycles of outperformance and underperformance versus each other. Definitions can differ, but Growth stocks are usually viewed as companies with higher expected earnings growth and higher valuations. Value stocks tend to be more cyclical, and are expected to grow earnings at a slower pace, but with lower valuations. The company Russell Incorporated (“Russell”) has built numerous indices to divide stocks of all sizes into “growth indices” and “value indices.” In summary, Russell essentially defines a growth stock as one with high expected earnings growth and a high price-to-book value. A value stock possesses a lower expected earnings growth rate and a lower price-to-book value. What sectors are more heavily growth or value biased?
Due to their higher growth and expensive valuation, Technology stocks are prolific in a growth index, while Financial and Energy stocks are more prominent in a value index. For example, the well-known Russell 1000® Index is an index of approximately the 1000 largest stocks. Russell created a growth index and a value index from the 1000, with nearly 40% of the Russell 1000® Growth Index comprised of Technology, and nearly 40% of the Russell 1000® Value Index comprised of Financials and Energy stocks.
As mentioned earlier, over long periods of typically 8-10 years, growth can outperform value and vice-versa. About every 8-10 years, the return differential reaches an extreme point when one type of stock has dramatically outperformed another on a long-term basis. History has shown at these extremes, such as 1987, 2000, 2009, and now today, the probability is high for a reversal in trend. Not only has sentiment typically reached an extreme in favor of one type of index, but the relative valuation an investor is required to pay for a particular growth rate is usually stretched. On the next page, you can see a chart of the relative 10-year annualized return of growth stocks versus value stocks. When the line is rising, growth is outperforming value. When the line is falling, value has outperformed growth.
To see how extreme the growth versus value return can stretch, simply find the year 2000 right as the internet bubble popped. At that point, growth stocks had outperformed value by 6% annually for 10 years. At this extreme, growth stocks were certainly growing earnings faster than value, but the valuations for growth were extreme – the premium to own growth stocks was far too high. For nine years after this point, this premium gradually reversed until 2009 when value had now outperformed growth for 7% annually for 10 years. In 2009, the OPCM investment team felt the potential future growth rate for growth stocks was high coming out of a recession, while the valuation differential between growth stocks and value stocks was nearly zero. Over the next few years coming out of the recession, the majority of the new buys in our portfolios were growth stocks – from mobile phone companies, to online retailers, to semiconductors to internet-based companies.
Fast forward to this year, and the Russell 1000® Growth Index is up 22%, while the Russell 1000® Value Index is up 8% in 2017. However, just as growth stocks had become extended versus value stocks in early 2000, we now see similar characteristics today. First, growth has now outperformed value by nearly 4% annually over the last ten-years. Only early 2000 saw a wider performance difference. Second, the Russell 1000® Growth trades at a P/E on future earnings of more than 25x, with value less than 18x. Third, the year-over-year earnings comparisons for growth stocks start to become difficult over the next quarter, while many value company earnings are set to inflect higher. Finally, other variables are becoming tailwinds for value stocks, such as the dollar, interest rate spreads, the Federal Reserve, and wage inflation. Couple these with the future rebuilding from the twin hurricanes, and many states recently announcing future spending increases on infrastructure, and value could be poised to reverse the last decade of underperformance. Plus, on a relative basis, growth is now trading at a very high premium to value on a price-to-book value and forward P/E basis, with potentially similar earnings growth characteristics next year.
In conclusion, not only are we finding more potential future “growth in value”, but certain areas of growth appear to be extremely risky at this point. The Russell 2000® Small-Cap Growth Index trades at a bubble-like P/E of 35x aggressive forward earnings, while the FAANG and other high growth/high value companies look vulnerable to us, hence our recent portfolio reductions in some of these companies. We believe the majority of the best risk/reward situations in U.S. equities lie in value oriented companies that trade at significant valuation discounts, with lower risk profiles, positively inflecting fundamentals, and a future environment that is likely to be more supportive.