The great debate on value investing

Today’s ‘market rally’ has been driven by a handful of stocks trading at a premium. How long can this last?

It seems every week we see articles presenting opposite views on value investing: “Value investing is dead” vs. “Valuation differences between growth and value aren’t sustainable.” Is this time really different?  Can growth continue to outperform with such concentrated leadership?

As value investors, we think that valuations and fundamentals will eventually prevail. However, the million-dollar question is when? Although we don’t know the exact timing, we do have plenty of data to suggest that when this does occur, mean reversion could provide a healthy backdrop for value investing.

Unchartered territory

Prior to this recent period, value underperformance last occurred in the late 1990s, as unprofitable companies created a bubble in a momentum-driven, narrowly-led rally.

Periods of underperformance like this are not new to value investors – they are cyclical. What is unusual is this latest cycle’s duration and the magnitude of the underperformance.

Let’s look at the difference between growth and value stocks over the past decade.

The current growth cycle has been meteoric

Could a rotation be on the horizon?

Source: Kailash Capital.  Data is from 4/30/1989 – 6/30/2020.

During this last cycle, the length and magnitude of underperformance is like nothing we’ve seen in decades. In fact, the dispersion in performance between growth and value is sitting in the 100th percentile. In other words, we’re in unchartered territory. We must ask the question: Is this sustainable over the long term?  Any investor that has a contrarian bone in their body is scratching their head over this. 

As many of us know, growth has outperformed value by epic proportions recently. Value and growth have always moved in cycles and outperformed each other over various periods of time.  Going back to 1945, value has only underperformed growth during six cycles, with the latest cycle starting in 2010 and continuing now.

Value has underperformed growth only six times since 1945

Source: Copyright 2019 Kenneth R. French at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/ as of September 2020. All performance information is hypothetical and not the actual performance of an investment fund. Historical performance is not necessarily indicative of future performance. The chart above plots the trailing five-year annualized return of a hypothetical portfolio. When value stocks outperform, the lines go up. When growth outperforms, the lines go down. A value stock is defined as one having low Book Equity to Market Equity. In this case, we are looking at the relative performance of the 20% least expensive companies in relation to the 20% most expensive companies. All returns are compounded monthly.               

As you can see from the chart above, in the latest cycle, there have been a few “head fakes” where value has outperformed growth.  The most prominent period was after the 2016 US presidential election when financials rallied on the hopes of a reprieve from massive regulation, and energy stocks rallied as oil prices moved from the upper $20s at the beginning of 2016 to the low $50s by the end of the year. 1 

Historically, value has outperformed leading out of a recession; however, this wasn’t the case coming out of the Global Financial Crisis (GFC). So, why has value underperformed growth by such a large margin and for so long? 

  • Economic recovery post GFC was anemic, at best, with GDP averaging only 2.3% for the past decade. 2
  • Stimulus from the Federal Reserve (Fed) in the form of keeping interest rates artificially low through quantitative easing.
  • Macroeconomic headwinds.
    • Two major oil price wars from Q4 2015 to Q 2016: OPEC increased supply, lowering oil prices to gain market share.
    • China Trade War from 2018 to 2019:  major decrease in global demand.
    • COVID-19 global shutdown: massive drop in demand, affecting most equity sectors, outside of technology.

Market concentration

As we watched the S&P 500 rally through August, it’s important to note what’s actually driving the “market” returns.  The answer is – the “market” isn’t rallying; rather, a handful of stocks have been driving the entire market’s returns.

Most investors are familiar with the FAANG stocks – Facebook, Apple, Amazon, Netflix and Google (whose parent company is Alphabet). Add in Microsoft, and you have the “Sexy Six.”  If you look at the percentage of the total market cap this handful of stocks represent, investors should note that diversification is decreasing in the “market” as a larger allocation is much more concentrated in these stocks. 

The chart below shows the dramatic rise in market concentration of the top five stocks in the S&P 500 Index — today’s concentration levels far exceed the dot-com bubble era of 1999-2000 and are approaching the “Nifty Fifty” era of the 1970s, two bubbles that eventually burst. It is also important to note that the “Sexy Six” stocks represent almost 40% of the Russell 1000 Growth Index. 

Market concentration has increased exponentially in the last few years

Source: Ned Davis Research, Inc. Monthly data 1/31/1972 to 7/31/2020

Now, if you look at the concentration of the top five stocks as of July 31, 2020, alongside their corresponding price-to-earnings (P/E) ratios, as shown in the chart below, it’s easy to see that the market “rally” is only a few stocks driving market returns.  And, those few stocks are trading at extreme valuations.

Just five stocks account for the bulk of returns, while trading at a massive premium to the rest of the market

Source:  Standard & Poor’s, Thomson Financial, FactSet Research Systems, Inc. and Credit Suisse.

Is this time different?

Most investors are looking for diversification to make sure their portfolios have the unique risk/reward characteristics required to meet their investing goals. We believe the concentration risk in the market is a risk many investors are currently taking; it is a risky bet or gamble on prices going higher than the next dollar invested. Both the S&P 500 Index and Russell 1000 Growth Index are currently far from diversified in our opinion.

While the current rally in growth investing seems to be never-ending, now is the time to be reminded of some important rules of investing:

  • The fact that no cycle lasts forever is crucial to long-term investing. Understanding investing cycles suggests that after significant outperformance over an extended period, by definition, investments become more prone to drawdowns versus further upside.
  • True diversification means parts of your portfolio are lagging, while others outperform (i.e., low to negative correlation between asset classes, styles, etc.)

Now may be the time to consider reviewing your portfolio to ensure you are “truly” diversified. By doing so, you will follow the simple advice that is so difficult for many of us to adhere to – in order to buy something low, you must be willing to sell something high.

Footnotes

1 Source: Yahoo Finance historic WTI oil prices.

2 Sources: The Bureau of Economic Analysis; The Balance, “US GDP by Year Compared to Recessions and Events”

Important Information

Blog header image: PM Images/ Getty

The mention of specific companies does not constitute a recommendation by Invesco Distributors, Inc. Certain Invesco funds may hold the securities of the companies mentioned. A list of the top 10 holdings of each fund can be found by visiting invesco.com.

Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should ask their advisors for a prospectus/summary prospectus or visit invesco.com.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Holdings are subject to change and are for illustrative purposes only and should not be construed as buy/sell recommendations. Past performance is not a guarantee of future results. An investment cannot be made directly into an index.

The S&P 500 Index is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

A value stock is defined as one having low book equity to market equity and typically trade at low price/earnings (P/E) ratios.  A growth stock is defined as a company that is expected to grow sales and earnings at a faster rate than the market average. Growth stocks typically trade at high price/earnings (P/E) ratios.

Standard deviation measures a range of valuation spread disparities and identifies the level of short-term fluctuations.

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS)

Value Investing Style Risk. A value investing style subjects the fund to the risk that the valuations never improve or that the returns on value equity securities are less than returns on other styles of investing or the overall stock market.

The opinions referenced above are those of the author as of Oct. 23, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions.

Tracy Fielder is a Product Management Director and Co-Lead for Invesco. In this role, he works with Invesco’s US value investment teams and client portfolio managers to develop sales and marketing programs, positioning Invesco’s product lines across all global distribution channels.

Mr. Fielder joined Invesco in 2010. Prior to joining the firm, he was vice president of investment research at VALIC, where he was responsible for leading a team of analysts overseeing the selection and monitoring of all mutual fund managers and subadvisors utilized for defined contribution retirement plan clients. Before joining VALIC, he was an account executive at Van Kampen Investments, where he was in charge of marketing and sales for the Van Kampen mutual fund product line distributed by Morgan Stanley Dean Witter financial advisors. He entered the financial industry in 1993 as a marketing coordinator for PaineWebber.

Mr. Fielder earned a BBA, cum laude, with a concentration in finance from the University of Houston and his MBA from Houston Baptist University. He holds the Series 6, 7, 24, 63 and 65 registrations.

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