Never in the last 50 years have the valuations of growth stocks been so low as they are right now relative to defensive and traditionally value-oriented stocks.
For example, many high quality growth stocks such as AAPL are trading at forward PEs in low single digits while other high quality growth stocks such as ORCL and SNDK are trading in single digits. By contrast, high quality, high dividend-paying but much-lower-growth pharmaceutical and consumer durables companies such as BMY, KO and MCD are trading at PEs in the mid teens. Lower quality but higher dividend-paying stocks in the MLP sector such as are trading at forward PEs in the 20s despite flat to negative long-term growth rates.
Strategists have been loudly predicting a reversal of this valuation anomaly. However, these predictions have fallen flat for several years now. If anything, the anomaly has tended to deepen in time.
Why? Three reasons.
RISK AVERSION AND LACK OF FAITH IN THE FUTURE
Normally, 70% or more of the value of a company is based on its so-called “terminal value.” Terminal value consists of the discounted of future cash flows beyond the forecast range – typically ten years.
When evaluating the value of companies such as KO or MCD, it seems rather clear that they will be around ten years from now and beyond. In the case of tech stocks such as AAPL or SNDK, many investors fear that due to the pace of technological innovation (that can make products obsolescent from one moment to the next) and the concomitant extremely short product cycles, it is not possible to predict if most tech companies will even be around ten years from now.
Bull markets are characterized by faith in the far future. However, in times such as these in which risk aversion is extremely high, investors will tend apply a very high discount to the terminal value of technology and other growth-oriented stocks given that such a value is based on difficult-to-fathom events far into the future.
Related to the above point is the fact that investors have remained in a state of shock after the 2008-2009 experience. On the margin, investors have been more inclined to seek low volatility stocks, with higher visibility of book value and cash dividends.
This is simply anther manifestation of the general “flight to safety” syndrome affecting financial markets more generally. This is exhibited by such observable phenomena as extremely low yields in Treasury securities (even negative yields in some cases) and cash hoarding behavior at both the individual and company level.
THE STRETCH FOR YIELD
The low yields on fixed-income securities have driven many investors to high-dividend yielding stocks given that the latter sport higher yields. This sponsorship by former fixed-income investors has helped prop up the valuations of high dividend paying stocks.
Furthermore, the combination of the thirst for yield and low funding costs have encouraged the growth of highly leveraged strategies employing high dividend yielding stocks. Such strategies, including the use of margin leverage and the sale of naked puts and calls at strike prices below and above the current stock price have become extremely popular. All of these leveraged income-generating strategies have driven investor demand for high yielding stocks increasing their market value.
The relative overvaluation of defensive and traditionally value-oriented stocks relative to growth stocks has reached almost bubble-like proportions in some sectors of the stock market. Investors are stretching for yield and “safety” at almost any cost – including paying extremely high PEs for stocks that have projected negative growth rates.
While it is unlikely that risk aversion and hunger for yield will decline in the short term, dividend investors seem to be gravely underestimating the risk inherent in the presumably “defensive” stocks that they have been piling into.
Overvaluation, in both absolute and relative terms, as well as the potential unwinding of leveraged positions involving high dividend-yielding stocks are major dangers faced by investors in traditionally defensive and value-oriented sectors.
Having said that, growth-oriented investors should not be overly sanguine. In a general market decline, growth stocks will go down in absolute terms as well. It may be, however, that beta’s for growth stocks may be lower than they have been in other bear markets historically.
That may serve as little comfort for most ordinary investors. However, the notion of losing less money than the competition is the Holy Grail sought after by most fund managers whose performances are typically measured by relative return metrics.