Stocks perceived as mitigating the effects of market volatility were popular among investors in the first quarter. Big swings in equity markets drove a flight to quality that benefitted dividend-paying sectors such as Utilities and Telecommunication Services (which were the two best-performing sectors in both ACWI and the Russell 3000). We largely have avoided those sectors due to their elevated valuations and the fact that we don't believe they offer the growth possibilities that are necessary to generate long-term returns. While some high-profile growth stocks trade at triple-digit P/E valuations today, the reality is that the vast majority of growth stocks do not, and we do not believe it is worthwhile to examine what is happening with the growth story.
The case for growth stocks in a low-growth world is relatively straightforward. All else being equal, companies that are capable of delivering above-average growth in a low-growth world should be rewarded by investors over time. However, in investing, all else is rarely equal. A high-growth stock at an unsustainably high valuation can be just as risky as - or even more risky than - a company that is in secular decline. 2015 was the best year since 2009 for major U.S. growth indices (e.g., Russell 1000 Growth, S&P 500 Growth) versus their value counterparts (e.g., Russell 1000 Value, S&P 500 Value), so it makes sense to take a deeper dive.
The median growth stock trades at a similar valuation (on both an absolute and relative basis versus non-growth stocks) to where it started 2015. For example, the median P/E of Russell 1000 Growth stocks that have no weight assigned to the Russell 1000 Value traded at a next 12-month P/E of 19.4 at the start of 2015. This group of stocks entered 2016 with a very similar next 12-month P/E of 19.5, and ended the first quarter at 19.7. Absolute valuations for this group as a whole are not cheap, and therefore, risks associated with coming up short of investor expectations can be high. However, the premium for these high-growth businesses versus the rest of the Russell 1000 is well within historical norms (see chart below). Against this backdrop, we continue to seek opportunities to own well-positioned, growth-oriented businesses with valuations that offer attractive compensation for the risks taken. The number of such opportunities might be fewer than earlier in the current market cycle, but we believe a selective and active approach to investing can maximize the likelihood of finding such companies today.
Investing in companies that can grow their earnings at rates above the trend in broad economic growth is particularly important in today's slow-growth economy. As an illustration, we've taken returns in the U.S. equity market on a rolling 10-year basis and broken them down into how much came from earnings growth and how much came from changes in the P/E multiple (i.e., multiple expansion or contraction). Beginning in 1970, it has been earnings growth that has been more consistent and stable most of the time (see chart below). Historically, earnings growth has been a more reliable contributor to the returns we get as investors than multiple expansion.
While there certainly are periods in which multiple expansion drove or provided a boost to returns, changes in multiples have been quite volatile. In the 1980s and 1990s - when multiple growth helped returns - the market was coming off some attractive starting valuations and had a backdrop that was favorable for rising valuations. As a result, there was solid multiple expansion. But before that - and, more importantly, recently - not only could investors not rely on multiple expansion, they also had to deal with multiple contraction. This is one illustration of why we believe it is particularly important right now to focus on companies that are capable of growing their earnings on an individual basis, which, in our view, puts investors in a much better position to generate positive returns.
Past performance does not guarantee future results.