By Steve Tepper, CFP®, MBA
From the day Northstar was founded nearly 20 years ago, we have had a consistent investment approach rooted in the world of academic study. What do the Nobel Prize-winning economists doing intense research into market behaviors tell us about investing?
The most reliable research, in our opinion, tends to come to the same conclusion: Investing is an exercise in risk-and reward, and the most successful investing is done when you maximize your reward for the risk you take.
One of the most important factors in getting reward for risk is through value investing. The work of Eugene Fama of the University of Chicago and Kenneth French of Dartmouth tells us that over time, there is a premium (fancy way of saying “better return”) for investing in companies that have a low value when comparing their stock price with the value of their assets (aka “book value”). We don’t invest only in value, but it’s one area that we look to for premium.
The opposite of value companies are growth companies, which have a very high stock price relative to book value. Think of a company like Uber that earned valuations of billions of dollars while having little or no hard assets—maybe just an app and a few people working in a small office space.
Growth companies are “sexy.” They get the press coverage. They get investor attention, particularly those investors, and fund managers, looking for the home run, the stock that will rocket up in price and make you a fortune.
And to be sure, the home-run growth companies have provided extraordinary returns. In six months in 2018, Netflix stock doubled in price. In one of Apple’s many growth spurts, from 2009 to 2012, the stock price went from $12 to $95. And perhaps the No. 1 growth stock of them all, Google, has gone from $50 in 2004 to over $1,400 as of late May 2020.
If there are value stocks with that kind of performance, I don’t know of them.
But like a lot of Major League Baseball sluggers who hit a lot of home runs, growth stocks also have a whole lot of strikeouts. Remember Pets.com? The online pet supply seller fell from $11 per share to $0.19, taking $300 million of investor money with it.
So while the home runs usually come from growth stocks, so do an app-load of the failures, to the point that when you look at growth stocks as a group, they are more likely to underperform value stocks over time. And that makes sense too. If you looked at the world of internet search engines 20 years ago and said, “I’ll invest in Google,” well, home run. But did you have any reason to think Google would end up being the only player left in a crowded field just a few years later?
Just as likely you might have picked Lycos, Alta Vista, Go, Infoseek, Wikia, Excite, or Ask Jeeves. Remember them? All competitors in the search engine space a couple decades ago. And as investments, all strikeouts. The only way to be sure you picked the search engine winner would have been to invest in all of the above. That’s at least seven strikeouts to one home run, an average of .125. Do you know what you call a baseball player with a .125 batting average? Minor leaguer (if he’s lucky).
So now that you are fully onboard with value investing, here’s the bad news: Value stocks as a group have been underperforming growth for quite some time.
For 10 years back to March 2010, value stocks’ annualized return has been 5.06%, vs. 13.04% for growth.[1] Not even close—it’s a butt whoopin. And our client portfolios with a tilt toward value have reflected that underperformance.
The poor returns of value stocks have been so pronounced they’ve led to a widening gap between value and growth, as seen in this chart:
The chart shows stock price to book value taking off for growth stocks in 2009 (as they did in the late 1990s during the original dot-com bubble), while value has stayed pretty flat. As investors. it would be tempting to conclude that we are in another bubble and that a shift from growth to value would be wise. But then along comes research telling us that might not be the case.[2] The research says switching between growth and value based on the spread shows no better return historically than a buy-and-hold strategy.
On the other hand, it remains reasonable to expect that securities with lower prices relative to fundamentals should have higher expected returns. The value premium does not show up every day, year, or decade, and we have no way of predicting when it will. It’s risky. And the only way to ensure you are rewarded for the risk is by maintaining consistent exposure to value, regardless of recent performance or current valuations.
1 - Based on Fama/French US Value Research Index and Fama/French US Growth Research Index.
2 - Wei Dai, Premium Timing with Valuation Ratios (white paper, Dimensional Fund Advisors, 2016).