The danger of ‘this time it’s different’
At a 1998 Federal Reserve board of governors meeting held to post-mortem the corpse of Long Term Capital Management, a trader in attendance commented that “more money has been lost because of four words than at the point of a gun. Those words are ‘this time is different’“.
These words seem very apt in the current environment.
Australian investors are looking at stockmarkets at extremely elevated levels that have provided investors with years of historically above-average returns. There has also been a long period where, unusually from a historical perspective, growth stocks have outperformed value stocks.
Perhaps unsurprisingly, investors – particularly those who have only been investing for a decade or so – feel pretty much invincible after so many years of outstanding returns.
There is a strong sense that this time, it is different – that markets will continue to perform well from their current elevated levels, and growth stocks will continue to outperform value stocks.
As value investors we know that straying from the fundamentals of sensible valuation rarely ends well and that eventually, inevitably, this time will not be different.
What does past performance tell us?
We are all very familiar with those disclaimers advising that past performance should not be relied on as an indicator of future performance. However, what they should really say is that past performance over long periods is in fact a great indicator of future performance, while performance over the short-term is not.
Just because markets have been on a growth tear for the past 10 years, this doesn’t mean that it won’t come to an end. Despite the best efforts of those who try to convince investors that “this time it is different”, or that “markets have fundamentally changed” – a glance at history will show this is not the case.
The truth is, there has always been significant reward for those who had luck or skill and got in early with the gamechangers of any generation (think Nifty 50, Bell or the Argentinian railroads).
Likewise, anyone who says that value investing is dead, and long live growth investing, needs to look further back than the last 10 or so years of history. Fortunately, there is a century of stockmarket data to study.
Over very long periods of time, research suggests value investing strategies outperform growth strategies by a substantial margin. As can be seen from Chart 1, a balanced value strategy in the United States, defined as 50% small and 50% large-cap equities, would have made your investment 50 times more valuable than a balanced growth strategy since 1926. Intuitively this makes sense – if you maintain the discipline of buying low and selling high, you should be rewarded handsomely over the long-term.
However, the past 12 years have been very different. Growth strategies have outperformed value by some margin across global markets, boosted by the low interest rate environment and trillions of dollars in government stimulus packages that have helped balloon valuations of growth and loss-making companies.
HISTORY OF VALUE
Value investing to us means investing in companies that we believe are trading below their intrinsic value – our assessment of what the company is worth.
Our valuations focus on the present value of the cashflows we expect from a stock after capital expenditure and working capital requirements. It is important to a value investor that a target company can grow its cashflows over time. We also consider the support tangible assets provide to our valuation and ensure we are satisfied with the quality of management and the durability of the intangible assets such as brands. A tangible asset backing may also provide a level of downside protection, which is also important to a value investor.
As value investors, we attempt to buy stocks with growth potential at a reasonable price. Growth is an essential requirement for us, we just won’t overpay for it.
It’s also important to note that a particular stock does not stay a ‘value’ or ‘growth’ stock forever, and sometimes stocks are held by both value and growth investors at the same time. A stock may also be a value or a growth stock at different times in its lifecycle.
As an example, in Chart 2, between 2013 and 2017, Apple was held in both value and growth fund portfolios. However, from 2019, and particularly since the onset of COVID-19 in 2020, Apple has posted solid earnings growth and, importantly, investor expectations for future strong growth have increased considerably. Although the base business of Apple is still very similar to pre-COVID days, those strong investor expectations have resulted in Apple trading on a significantly higher price earning multiple and therefore most value funds would no longer be investors in the stock.
INTEREST RATE IMPACT
A glance back at history provides some context - that growth strategies tend to outperform in a decreasing interest rate environment. So, while the environment of low interest rates may be good for growth and loss-making companies for now, this will likely change once interest rates rise.
It is uncertain how long interest rates will remain low, but rates will rise at some point and many growth companies will be caught out, particularly if they are loss-making with already meaningful debt levels that will necessitate continually tapping the public markets for further capital to survive. On the other side of the spectrum, the stock prices of popular defensive stocks, so-called blue chips, trading on all-time high margins and earnings multiples, are also at risk from rising rates as investors are likely to demand higher earnings and dividend yields.
SO IS THIS TIME DIFFERENT?
Most concerningly to us, we believe that investors have become complacent and are taking on more and more risks by investing in loss-making entities with popular growth narratives.
A lot of investors are trying to find the next Tesla or FAANG stock as they read and hear of stories of people making vast fortunes in a short amount of time. In this context, the sales-driven stories of brokers and market commentators sound very convincing when seemingly everybody is making easy money. Some companies are tapping into this sentiment and selling investors stories that are too good to be true and may even ultimately lead to a permanent loss of capital.
Investors should be aware that historically, each time the anomaly of growth outperforming value strategies has occurred, it has been followed by a market crash. The only thing unique about the situation we are in now is the length of time that growth investing has outperformed.
We are already seeing some ominous signs of a top-heavy market. When some form of reversal happens, portfolios with allocations to value, and particularly small-cap value, will most likely outperform again and growth stocks will come crashing back to reality.
James Williamson is co-founder of Wentworth Williamson Management.
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