Value Investing Is Back - Is It Here To Stay?
- I expect value to beat growth by 20%-30% over the next few years.
- Fundamental factors are turning in favor of value.
- Current pricing gaps are wider than they should be.
- This idea was discussed in more depth with members of my private investing community, Portfolio Income Solutions. Learn More »
2016 was the last year in which value beat growth and after 4 years of full on growth favored market, value is coming out ahead in 2021.
Will it revert back to growth leading or is value here to stay?
While the future is unknowable, there are factors we can look at to get a sense for its most likely path.
Consider a baseball tossed up into the air. We do not know for certain where it will land, but we can look at its current trajectory, velocity, friction and gravity to map out where it should end up.
In theory, the landing point is deterministic, but in practice there are often unforeseen factors. Maybe the air is more humid than we thought leading to different friction than calculated.
The market works the same way. Based on observable data and analysis we can approximate where stocks should move, but in practice, sentiment or black swan events mess with the outcome.
Physics cannot tell you exactly where the ball will end up, but it probably gets you pretty close. Similarly, we cannot know exactly where the market is headed, but good analysis will help us hone in on where it is most likely to go.
Growth or Value, what is the better investment right now?
The answer lies in relative valuation of growth and value.
Since growth stocks grow faster by definition, they should trade at higher multiples than non-growth stocks. Thus, the growth index should trade at a higher multiple than the value index. The question we are really looking at here is how much higher multiple should the growth index have?
Is 5 turns higher on earnings multiple appropriate? What about 10 turns or even 20 turns?
The delta in multiple should be proportional to the delta in growth rates. If the growth index is only growing slightly faster than the value index the multiple difference should be small and if the growth gap is large the multiple gap should be large.
Going forward, I think the difference in growth is rather small and right now the difference in multiple is quite large. Thus, I think value will continue to outperform.
This conclusion relies on 2 statements being true
- The disparity in valuation is larger than normal
- The disparity in growth is smaller than normal
To demonstrate the truth of the above statements let us look at the iShares Russell 1000 Value ETF (IWD) as compared to the iShares Russell 1000 Growth ETF (IWF).
Disparity in valuation is larger than normal
In recent months value has significantly outperformed growth with a 6 month return of 28.83% as compared to 11.28% for the growth ETF.
This is just the tip of the iceberg in terms of undoing the extreme price movement that went the other way beginning in 2017 and hit its apex in 2020.
That is an 85 percentage point disparity in performance over the last 5 years with growth absolutely clobbering value.
If you were in growth, congratulations, but now it might be time to switch because the minor outperformance of value in the past few months is likely just the start of correcting this imbalance.
The massive outperformance has left the growth index at an extremely high P/E multiple of 34.69. The IWD value ETF trades at a PE of 22.37 making it more than 12 turns cheaper than the growth.
Such a large disparity in valuation could be justified if the forward growth were substantially faster for the growth index, but this brings us to our next point.
Growth disparity is smaller than normal
In this case, growth is referring to future earnings growth so it is a projection rather than data. There is, however, good reasoning to believe that value stocks are headed for a period of better than normal growth and growth stocks are headed for a period of lower than normal growth.
Value stocks tend to be more cyclical in nature so they were disproportionately hit during the pandemic and should be disproportionately benefitted coming out of the pandemic as the economy continues to recover.
Growth stocks tend to be more tech based and the pandemic pulled forward demand for various tech products and services. I don’t think they will be harmed by the economic recovery, but because they tend to be more economically agnostic, they will not benefit nearly as much as the value names.
These are of course generalizations. There will be a spectrum of performance within value and within growth, but overall as a weighted average, I would expect value to have better than normal growth and growth to have worse than normal growth.
As such, the gap in multiples should be smaller than normal, not bigger than normal, so I expect value to outperform growth until the multiple gap is normalized.
Interest rates also play a role
One of the big driving factors in the outperformance of growth over the past 5 years has been the zero interest rate environment. Free money makes investing in long run growth very accretive. Once that money starts to have a carrying cost, the growth capex becomes less accretive, substantially slowing the growth of growth stocks. Well, money is no longer free like it has been over the past 5 years. Compared to 1 year ago, the long end of the treasury curve is more than 100 basis points higher.
This is probably the biggest factor in the recent resurgence of value. It is also the most known factor to the market.
The improved growth rates of value stocks and reduced growth rates of growth stocks will start to hit the market’s consciousness as earnings reports start to get the pandemic quarters as year over year comps. Suddenly the value stocks that had to stall their businesses are going to be having great quarters and the growth stocks that pulled forward demand (think Netflix or Peloton) are going to have really tough comps.
Projected magnitude of value outperformance
Given the reduced disparity in growth rates between the indices, I think an appropriate multiple spread between value and growth would be somewhere between 5 and 7 turns.
So rather than the iShares Russell Value ETF trading at a PE of 22.37 and the iShares Russell Growth ETF trading at 34.69X that gap should shrink.
Depending on how the market goes, it could be value stocks coming up or growth stocks coming down, but my best guess is a bit of both. The shrinking of the gap would represent about 20%-30% outperformance of value over growth.
How to play it?
If you are okay with a market return minus the 19 basis point fee that IWD charges, it is a legitimate way to hold diversified value stocks. Those who follow my work know I am stock picker and frequently critical of ETFs but I can’t find too many gripes with IWD. Each of the top 10 holdings is a legitimate business and established value companies as a group are well positioned.
But, if you are like me and looking for something better than a mere market return, Single stock picking is the way to go.
Most value indices, IWD included are going to be underweight technology for the simple reason that most of technology trades at very high multiples. As technology has certain fundamental strengths I find this underweight regrettable, but at the same time I don’t want to overpay for exposure.
The solution here is to find stocks with strong tech fundamental exposure that happen to be trading at value prices. 2 value tech picks are Uniti Group (UNIT) and Lumen Technologies (LUMN). Both are fiber companies and I really like the strategic positioning of fiber. Just about every area in tech relies on fiber to transmit its data.
- Cloud computing
- Edge computing
- Data centers
All of these need fiber and as the demand grows these companies can lease out their fiber at high incremental margins.
This makes UNIT and LUMN inherently growth companies, but the growth is not yet recognized by the market as they trade at low multiples.
- Uniti is at 6.8X forward AFFO and these cashflows allow it to pay a 5.4% dividend with a low payout ratio.
- LUMN trades at 8.4X forward earnings which allows it to pay a 7.6% dividend yield while retaining cash for growth.
I view the 2 as complimentary holdings rather than redundant because differences in their networks aim them at different end customers.
Uniti group (top map) is more last mile fiber while Lumen is more focused on long-haul and international fiber.
Sources: UNIT and LUMN, respectively
This makes UNIT well suited for 5G small cells and Lumen well suited for enterprises that want ultra-low latency edge computing.
Wrapping it up
I firmly believe that the resurgence of value has a long way to run. Over the next few years I anticipate 20% to 30% outperformance for value over growth. A low cost value ETF like IWD could be an okay way to play it, but my money is in hand selected individual stocks.
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Analyst’s Disclosure: I am/we are long UNIT, LUMN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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