Overpaying for Growth
Even with growth’s continued dominance, Charlie Bobrinskoy believes that — based on history — value investing will outperform.
It’s no secret that growth companies have outperformed value companies recently.
Technology companies have led the growth stock outperformance, with Amazon (AMZN), up 67%% year-to-date, and Netflix (NLFX), up 96% year-to-date (as of October 4, 2018). Amazon and Apple (AAPL), are the first two companies to reach $1 trillion valuations, and technology makes up 26% of the S&P 500 index, the sector’s highest weighting since 2000. Many investors have very optimistic outlooks for these firms. Amazon is trading at a price-to-earnings (P/E) ratio of 161 and Netflix’s P/E ratio is 171, just two examples of the exuberance investors have for certain growth stocks.
Growth’s current outperformance over value has lasted much longer than we at Ariel have expected, bucking the normal and historical trend of value besting growth. We’re not calling for a shift in sector dominance, but we want to point out the only other time growth outperformed value for any length of time occurred during the dot-com boom.
We saw how that movie ended: in a bust where dot-com buyers ended up overpaying for growth. The current growth-over-value story could be a sequel that has the same ending.
In the beginning of 2000, the 10 largest U.S. market-cap technology stocks together comprised a 25% share of the S&P 500: Microsoft, Cisco (CSCO), Intel (INTC), IBM (IBM), AOL, Oracle (ORCL), Dell, Sun, Qualcomm (QCOM), and Hewlett-Packard (HPQ).
These stocks did not live up to then-investors’ extremely optimistic expectations. From 2000 to 2018, none beat the market. Five saw an average 3.2% annual compounded return, far below the market return. Five saw negative returns, with the average outcome a loss of 7.2% a year, or 12.6% a year less than the S&P 500. Two failed outright.
With so many of today’s technology stocks priced for perfection, it takes very little for them to stumble. A well-publicized example is Facebook’s (FB) 20% drop in late July, the day after missing second-quarter earnings. Twitter’s (TWTR) stock also fell 20% in July after it reported a fall in users. Neither has recovered. Salesforce.com (CRM) announced a strong quarter in late August, but the stock fell 3% after the news, cutting its earnings outlook to 61 times trailing earnings versus 63 the day prior.
Weakness in those technology names helped the Russell 1000 Value index outperform the Russell 1000 Growth index on a spread basis in July for the first time this year. (However, the value index continues to underperform growth overall.)
Even with growth’s continued dominance, we believe value will still outperform in the long run, based on history. The outperformance of value over growth is one of the most-documented factors in academic research, and is one of the original factors cited in the academic work of Nobel-prize winning economists Eugene Fama and Kenneth French.
Look below at a rolling 10-year chart of annualized returns of the Fama-French value factor. The chart shows based on nearly 100 years of data, value outperforms growth, except for during the dot-com boom and now.
Figure 1: Value has nearly always outperformed growth—until recently
Rolling 10-year annualized return of Fama-French Value Factor, %
Past performance is not a guide to future performance and may not be repeated.
Based on monthly returns of the US Fama/French HML (High Minus Low) Factor, HML is the return on the “high” portfolio minus the return on the “low” portfolio, where book to market is used as the value metric. Source: Kenneth French’s Data Library and Schroders. Data from 31 July 1926 to 29 December 2017.
Why has value investing won over time? Two reasons: optimism and recency bias. As humans, we tend to be too optimistic when we are evaluating businesses or evaluating the economic outlook. Just as when companies put together their budgets, they tend to overestimate the good things that will happen and underestimate the costs and the bumps in the road along the way. When traveling, we often underestimate traffic or underestimate the final cost of a home-remodeling project.
Recency bias happens because people remember select headlines they’ve seen, and there are many headlines written about successful growth companies. It’s easy to recall how Steve Jobs built Apple, how Bill Gates built Microsoft or Jeff Bezos became the world’s richest man. But people can't recall all the failed technology companies that went bust. People tend to overestimate how easy it is to create great companies out of nothing. Likewise, there are fewer media stories of how companies slowly and steadily grow at 8% a year.
A final word on why growth is currently outperforming value. The extremely low interest rates in the U.S. and globally since the Global Financial Crisis has allowed growth stocks to flourish. The stock market creates a present value calculation on future earnings. With low interest rates, $1 in earnings 10 years from now is worth nearly as much as a dollar is earned today. However, if interest rates are high, that dollar in 10 years is worth comparatively less.
Low interest rates are very favorable for growth companies that may not be earning much today, but investors hope will be earning a lot in 10 years. If we experience an increase in interest rates, that will be negative for the valuation of growth companies and relatively positive for valuation of value companies, which are earning more of their money today.
Past performance does not guarantee future results.
In this commentary, Mr. Bobrinskoy candidly discusses his viewpoints of market conditions, growth versus value investing, and certain specific companies. The information contained in this commentary is not guaranteed as to its accuracy or completeness. It should not be considered investment advice. The opinions expressed were current at the time the commentary was written, but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
A growth investment strategy seeks stocks that are deemed to have superior growth potential. Growth stocks offer an established track record and are perceived to be less risky than value stocks. A value investment strategy seeks undervalued stocks that show a strong potential for growth. The intrinsic value of the stocks in which a value strategy invests may be based on incorrect assumptions or estimations, may be affected by declining fundamentals or external forces, and may never be recognized by the broader market.
Mr. Bobrinskoy discusses stocks which may be, or may have been, held in one or more of Ariel’s portfolios. Portfolio holdings are subject to change. The performance of any single portfolio holding is no indication of the performance of the other holdings of the portfolios or of the portfolios themselves. For top ten holdings of Ariel's mutual funds, click here.
Investors should consider carefully the investment objectives, risks, and charges and expenses before investing. For a current summary prospectus or full prospectus which contains this and other information about the funds offered by Ariel Investment Trust, call us at 800-292-7435 or click here. Please read the summary prospectus or full prospectus carefully before investing. Distributed by Ariel Distributors, LLC, a wholly-owned subsidiary of Ariel Investments, LLC. Ariel Distributors, LLC is a member of the Securities Investor Protection Corporation.