The Cyclicality Of Style And Location

The capital markets have grouped equities into two main divisions: growth and value.  These two groups are differentiated by the “style” of the companies in the group.  Investors are often confused about the differences between growth stocks and value stocks. The main way in which they differ is not in how they are bought and sold, nor is it how much ownership they represent in a company. Rather, the difference lies mainly in the way in which they are perceived by the market and, ultimately, by the investor.  The beauty is in the eye of the beholder, and that beauty has cyclicality that swings back and forth.  The below chart demonstrates the cyclicality of these styles.

Performance of GrowthMpi Stylus

The growth style identifies companies believed to generate superior long-term earnings growth higher than consensus growth rates implicit in the share price.  The value style seeks to identify companies that are undervalued by the market and are trading at a discount to their intrinsic value.

Growth stocks are associated with companies whose earnings are expected to continue growing at an above-average rate relative to the market. Growth stocks generally have high price-to-earnings (P/E) ratios and high price-to-book ratios. The P/E ratio is the market value per share divided by the current year’s earnings per share. For example, if the stock price is $52 per share and its earnings over the last 12 months have been $2 per share, then its P/E ratio is 26. The price-to-book ratio is the share price divided by the value of the company’s net assets per share. The open market often places a higher value per dollar of earnings on growth stocks.

Value stocks generally have low current P/E ratios and low price-to-book ratios. Investors buy these stocks because they are cheap with hope that they will increase in value when the broader market recognizes their full potential. Thus, investors believe that if they buy these stocks already at bargain prices, there is more safety from downside market risk.  If the stock market experiences a recession, the value portfolio will preserve more money than if they had invested in riskier, higher-priced stocks.

Going For Growth

Growth investors are attracted to companies that are expected to grow faster (either by revenues or cash flows, and definitely by profits) than the rest. As growth is the priority, companies reinvest earnings in themselves in order to expand, in the form of new workers, equipment, and acquisitions. Don't expect big dividends from growth companies—for them, it's grow big or go home. Growth companies offer higher upside potential and tend to be priced higher, therefore are inherently riskier. There is no guarantee a company's investments in growth will successfully lead to profit. Growth stocks experience stock price swings in greater magnitude, so they may be best suited for risk-tolerant investors with a longer time horizon.

Value Is What You Get

Value investing is about finding diamonds in the rough: companies whose stock prices do not necessarily reflect their fundamental worth. These businesses trade at a bargain share price. As the market cycle unfolds, theoretically the market will properly recognize the company's value and the price will rise. Additionally, since value companies are not investing as much into their own growth, they typically deliver profits to shareholders in the form of dividends.  Even if the stock does not appreciate, investors benefit from these dividend payments. Value stocks tend to be cheaper, therefore, can be less volatile investments than growth stocks.

Growth stocks:

  • More "expensive"— stock prices are high relative to their sales or profits.
  • Riskier — expensive now because investors expect big things. If growth plans don't materialize, the price could plummet.
  • Value stocks:

  • Less "expensive"— stock prices are low relative to their sales or profits.
  • Less risky — less expensive now because less growth is projected. Stock price appreciation isn't guaranteed, though—investors may have properly priced the stock already leading to a “value trap” situation where the stock remains undervalued for a long time.
  • Growth and value investments tend to run in cycles. Understanding the differences between them may help you decide which may be appropriate to help you pursue your specific investment goals. Regardless of which type of investor you are, there may be a place for both growth and value stocks in your portfolio. Rebalancing between the two styles may help manage risk and potentially enhance your returns over time.

    Growth and Value Today

    Let’s examine these two investment styles side by side as of Sept 30, 2018 and see the cycles they demonstrate.  This chart displays the historical returns for growth vs value style investing over various time periods.

    US Equity Index      YTD     1 Year   10 Years  20 Years

    Russell 1000 Growth   17.09  26.30     14.31         7.23

    Russell 1000 Value      3.92    9.45        9.79          7.64

    For the past ten years, the growth style has greatly outperformed the Value style.  However, for the last 20 years, Value has outperformed Growth.  What does that tell you about the first ten years?  That was a time for the Value style to have its day in the sun.

    Based on FactSet data, the 1,000 largest U.S. stocks by market capitalization are divided into deciles based on their beginning of year median forward price-earnings multiple. This P/E Ratio is one of the main differentiators between Growth and Value stocks.  For this 20-year period ending Sept 30, 2018, low P/E stocks did better than high P/E stocks.

    20 year average return by NTM P/E DecileFactSet data

    However, recently the opposite has been true as high P/E stocks have been outperforming low P/E stocks.

    2018 YTD returns by NTM P/E Decile a/o 09/30FactSet data

    Drawing conclusions strictly based on past time periods can cause a false sense of security as history rarely repeats itself in exactly the same way.  However, we have seen this phenomenon many times before.  One was at the end of the 1990s when high P/E stocks significantly outperformed low P/E stocks.  This was the dot com bubble.  Stocks with no earnings (and therefore P/E ratios of infinity) were appreciating while value stocks were all but forgotten.  Warren Buffett did not understand or believe in the technology bubble and was 50 percentage points behind the S&P500 by the time the tide turned.  Julian Robertson was more aggressive and shorted the growth stocks.  He experienced the old saying that “the markets can be irrational longer than you can be solvent.”  The trend built to a climax in 2000, followed by a severe reversal with years of outperformance by low P/E stocks.  Baron’s reported that as of the third quarter 2018, the outperformance of growth over value in the past 10 years erased a lead that value had over growth for 30 years prior to 2008. This is a cyclical “reversion to the mean.”

    The next two graphs show quite a significant difference in the performance of stocks separated into ten P/E ranges over the two years before 2000 and the seven years after 2000.

    2 year pre-bubble: 1998-1999 returns by NTM P/EecileFactSet Data

    7 year pre-bubble: 1998-1999 returns by NTM P/E decileFactSet data

    Growth and value are not the only two strategies of investing that experience times of over and under performance.  The cyclical nature of domestic and international investing has also experienced mean reversion over the past few decades.  The chart below shows a similar cyclical rotation pattern with different investment geographies.

    Performance leadership rotates between international and domestic stocksMorningstar Inc.

    Mean Reversion

    Few things remain constant in the ever-changing world of investments.  One theory argues otherwise.  Mean reversion is the concept that given enough time, individual asset class returns revert to their long run averages.  This reversion is not guaranteed, and cannot be timed, but in our experience has often proven valuable.  Above, you can see the relative outperformance of the U.S. vs international stock indices from 1980-2017.  The pattern for the past few decades has seen one location outperform and then the opposite right after.

    In the past year, U.S. equities earned +17.91%, while international stocks have only returned +2.75%.  While the relative outperformance and underperformance look striking by themselves, the underlying reasons must be understood if they are to serve as a guide to the future.

    In relatively efficient markets, traders have priced all available information into the markets.  The current U.S. stock market, and growth stocks in particular, are priced above historical average while the international markets and value stocks are priced below.  According to Robert Shiller, the PE ratio for the S&P 500 at the end of the third quarter was 24.  (The latest 1,000 point correction only brought the S&P 500's P/E ratio to 22.5 according to the Wall Street Journal.)  MSCI quotes the EAFE (international) P/E ratio near 15 with Emerging Market valuations even lower at 13.  According to Vanguard, the P/E for US growth stocks is 29, and the P/E for value is 16.

    There are indeed great cyclical opportunities and pitfalls in both.  If buy low – sell high is still a paramount investment rule, international companies and value stocks are a much cheaper buy today.


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