It’s no secret that value investing has struggled in recent years. Since the late 1990s, stock market history suggested that style of investing would lead, comfortably. But while value did indeed begin well, courtesy of the 2000-02 technology-stock crash, over the previous five-, 10-, and 15-year periods, growth is ahead.
The bad news for value investing is that growth stocks’ victory appears rational. The reason for owning value stocks is not that the cheaper firms are superior. The financial markets are not so irrationally priced that good companies can be bought for less, while inferior ones cost more. The logic is instead that the outlook for growth stocks is too high, and that for value stocks too low.
In recent years, it turns out, growth companies have fared well against the consensus. They were clearly superior at their time of purchase; they were expected to maintain that edge, by a certain margin; and they have matched, if not exceeded, those expectations. Growth has thrived because tech stocks have notched record profits. The stock prices have merely followed where the businesses have led.
Relative price/earnings ratios have gone nowhere for 16 years. Growth stocks traded optimistically when the millennium began, underperformed for two-and-a-half years, and have since maintained their relative standing. The P/E evidence indicates that growth stocks have earned their way to their success, rather than being buoyed by higher investor sentiment.
Of course, there are some caveats. One being that four companies – Apple (AAPL), Amazon.com (AMZN), Facebook (FB), and Google parent company Alphabet (GOOGL) have determined much of the outperformance of growth funds in recent years.
Tech Firms Have Unprecedented Powers
P/E ratios are but one method for measuring relative costs. Perhaps a different view would generate a different conclusion. The global economy has changed so that a few technology companies now enjoy rampant success. Their near-monopoly status permits them to expand without encountering significant competition. Where that will stop, nobody knows. However, we can address the second item by testing another ratio, which involves a dividing the current share price with the book value, the value of the company’s total assets.
Looking at the relative price/book ratios, in the grand scheme of things, the relative P/B ratio remains compressed when compared with its New Era excesses. But the fact that it is now above its 2002 levels is a warning sign. Also, one could reasonably argue that it’s acceptable for the relative P/B levels to rise, given that today’s leading growth companies have unprecedented powers.
The good news for value investing is that people naturally favour growth. As stock market writer and money manager Patrick O’Shaughnessy asks, would you prefer to own Uber stock or a taxi license? Most would opt for Uber. But O’Shaughnessy argues that the answer should be neutral before price is introduced. The taxi industry need not boom for the taxi license to be the better performer. All that is required is for taxis to retain their market share, or for Uber to hit a bump.
Growth stocks have been on a wonderful run, thanks to earnings reports that have surpassed even the optimists’ hopes. They will continue to perform well, as long as their businesses boom. However, the psychological reasons to believe in value investing remain intact. They will outlast current economic conditions.
