The Death Of A Value Salesman
"Cycles always prevail eventually. Nothing goes in one direction forever. Trees don't grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.” - Howard Marks
In this two-part series, I will explore the potential catalysts for a market correction occurring in the future. Based on market sentiment and continued growth, a pullback or correction could still easily be 12-24 months out, but as much more prominent and prestigious investors than myself have said, rather be early and prepared than late and confused.
My core thesis is the belief that when Value Stocks and Growth Stocks fall too much out of parity, a correction is more likely. We have seen these disparities during ‘08 and the tech bubble, and while we are not in a tech bubble, and our financial systems are much more sturdy then in ‘08, risk has increased, companies are priced to perfection, and the market thinks it is growing towards the sky. So what happens with the Death of a Value Salesman; and When Growth Stops Growing. Let’s see if we can find out.
"We have two classes of forecasters: Those who don't know and those who don't know they don't know”. - John Kenneth Galbraith
I never thought I would be one of those people buying up huge amounts of bottled water, powdered milk and cans of baked beans for my underground bunker to wait out the apocalypse, but that is essentially what I have metaphorically been doing with my portfolio. Over the course of the past 12 months, I have been overweight value among a broad array of sectors. Companies from energy, industrials, cyclicals, basic materials, REITs, yieldcos, shipping, and pharmaceuticals. I have tech and growth stocks mixed in, along with BDCs and bond funds, but I have personally noticed the stagnant growth and in many areas decline of value. And I thought I was buying these value stocks at undervalued prices already...only to see them go sideways, or in certain situations go down.
I’m not alone and small investors to large hedge fund managers are scratching their heads, and doubting the sanctity of Benjamin Graham and his religious teachings.
Can it be true? Can Value Investing be dead? It certainly appears so, and the stagnant growth for almost a decade would prove the theory. But is there more to the story? Do the seemingly bearish or hibernating value stocks paint a deeper picture within the markets and current macroeconomic trends? Is the current belief that Value Investing is no longer a viable trade, the exact catalyst needed to rebalance expectations and stop growth from growing over everything else?
I’d argue yes.
The hard data does not lie, and it hasn't been looking good for value for quite some time. The Russell 1000 Value Index has returned 9.7% this year while the Russell 1000 Growth Index has returned 24%.
The chart below explains what words can only go so far in doing. The chart shows just how clearly value has underperformed growth since the economic meltdown and the collapse of Lehman Brothers. Value has been punished mercilessly for its crime, and in some part justly so, while Growth has paved the way for financial prosperity and “growth”.
(Chart Source: Thisismoney.co.uk)
"The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy, [...] After years of running into the wind, we are left with no sense stronger than it will turn when it turns, [...] Perhaps there really is a new paradigm for valuing equities and the joke is on us. Time will tell.”
Howard Marks, the co-chairman of Oaktree Capital Group (OAK) and one of the high priests in Value Investing, released his annual memo earlier this year, highlighting the heightened risk he has seen in our epic bull run. Without regurgitating too much of the 22-page memorandum, he paints the current investment environment as stretched too thin and the prospective returns on future investments as across the board low. I think he sums up the memo, and in many ways, my own piece with this sentence he bolded:
“I think it’s better to turn cautious too soon (and thus perhaps underperform for a while) rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits and cut losses."
So Where’s The Value in Value?
I personally employ the value factor model when considering to further invest in companies I own or when considering dipping my toes into new companies/sectors. I like value investing, because it makes logical sense. We are told from youth that the stock market is skewed to the wealthy and insiders (and in many ways it was and still is), but with Graham’s piece de resistance, students of all ages and creeds could study and in some ways master the art of value investing. The concept is simple: buy stocks with the lowest valuations and sell those with the highest; yet to master it is a lifelong endeavor. To the dismay of millions, this approach has resulted in a cumulative loss of around 15% since the financial crisis, according to a Goldman Sachs Group, Inc. (GS) report.
Goldman Sachs equity strategist Ben Snider had this to say:
"The fundamental backdrop for value returns has been especially unfriendly in recent years, but these conditions are unlikely to persist (and are already moderating)[...]Nonetheless, the maturity of the current economic cycle suggests value returns will remain subdued in the near term.”
I tend to agree with his general statement and Goldman Sachs' take on the current death of the value salesman. The report went on to say that value stocks do well at the beginning of an economic cycle and underperform during times where the economic backdrop is weak and growth sluggish. Of course, this coupled with investors' boredom for slow growth from value only exponentially magnified their thirst for high-flying FAANG stocks - still seeing record growth across the board.
The chart below is a great historical visualization of how the cycles and bubbles affected each type of stock differently. Value outperformed almost for a decade against growth, starting with the Dot.com bubble...only to be stymied by the financial crisis of ‘08. It has been almost a decade of the inverse.
(Chart Source: Delaware Funds)
Another chart source shows the true numbers of the ebb and flow of growth and value through the ages.
(Chart Source: Fidelity)
I really like this chart, because it lumps the delta into five-year rolling periods. While it stops short of 2016-2017, it clearly depicts how value and growth take turns in growth over the past 26 years.
Fun facts: Between 1990 and 2015
Large-cap value stocks outperformed large-cap growth stocks 54% of the time (calculated using 24 three-year rolling periods)
Large value beat large growth 65% of the time (calculated using 17 rolling 10-year periods)
Small-cap value outperformed small-cap growth 73% of the time (calculated using the five-year rolling periods, and 82% of the time calculated using rolling 10-year periods)
It also further validates that value will win out in the end - a conclusion we are all hoping stays true!
A Pirate's Life For Me
"The best opportunities are usually found among things most others won't do." - Howard Marks
Being a contrarian investor and going against the herd is probably some form of masochism that Freud could write an entire book about. You are often calling wolf months, if not years away from it coming to fruition - but when it does, if properly positioned, you could laugh all the way to the bank.
The other children's story it reminds me of is the Little Red Hen. The main teachings are the virtues of work ethic and personal initiative, but I believe the deeper meaning is that of long-term planning - and a hedge against short sightedness. For those who don't know the story, the condensed version goes like this: The Red Hen asked for other farm animals to help plant grain. At each stage of the process (harvesting, threshing, milling the wheat into flour, and baking the bread), the hen asked others if they’d like to participate and they all said no. Only when she asked, who would like to participate in eating the finished loaf of bread, did they all want to join in. Of course, she replied that only those who worked for it got to enjoy it, and she ate it herself.
Star Light, Star Bright
Where’s the North Star, and what does this mean for me and for my portfolio allocation moving forward? Predicting the future is a tough game, and a sound investor will hedge for a multitude of possible scenarios. Like a master chess player, a great investor will see 50 moves ahead and understand how best to play his pieces, and even if a new piece is introduced, he can quickly identify the variance and update his position accordingly.
SO, with that what to do? Growth and tech will continue to outperform for the foreseeable future, and it is why many firms are overweight FAANG and will continue to be. They will make lots of money and push the stocks up to crazy multiples, as even modest growth from current levels, multiplied by the capital they are deploying, is massive in ROIC. And when value stocks start showing signs of resurgence, these firms will start pouring money into those sectors...probably leaving retail investors holding the bag for most of the overvalued tech/growth stocks.
I personally will continue to strengthen my positions within value while having a more keen eye on up and coming or small cap growth stocks. Small cap growth stocks still have the chance for alpha, and while will most certainly decline in any massive sell-off, will fall much less so than the FAANG stocks, and have a much higher chance to bounce back impressively in a shorter amount of time...not to mention may become the new FAANG.
I’m officially bearish on value and see it stay stagnant well into 2018 and even 2019 (barring any major unforeseen external catalysts). However, just because I’m bearish doesn’t mean I’m not gonna continue to buy up distressed and undervalued companies to fill up on for the long winter.
Stay tuned for part two of this series, where I explore the second catalyst for a market correction: When Growth Stops Growing.
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May your falling knives never cut too deep,
Remy Kouffman AKA The Knife Catcher
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.