Growth and value are the center of an everlasting debate about how one structures an investment portfolio. The story goes that value outperforms growth, and the bubble and bust of 2000-2002 deepened this belief. While I’m not disputing the integrity of the long-term data around returns, there are some important issues to keep in mind.
The first relates to the nature of the universes themselves. In a naïve split of any stock market, the cheaper half is the value stocks while the richer half is the growth stocks, whether it’s by earnings or book. The cheaper half tends to have more inherently condensed valuations. After all, it can only go from the median to zero. In normal conditions, not that many stocks trade at only a few times earnings.
By contrast, growth valuations can be nearly infinitely dispersed. In near any market condition, there are some companies which trade on massive multiples of earnings or book, sometimes for good reasons, but often not. When one examines return streams, it pays to keep this in mind. Avoiding overvalued stocks is as important to active growth investors as avoiding value traps is to value managers. Many companies with huge valuations are offering only a picture of past success, not necessarily future success, and investing is about the future. With careful attention to valuation, there is no inherent reason why active growth investments would necessarily trail active or passive value approaches. I believe this may be less true for passive investors who often invest in some very expensive issues which are part of the index. As a result, one might be more cautious about passively investing in growth equities.
Today the stock market has unusually compressed valuations (see chart). Cheap and expensive stocks are converging in the center. This suggests a lack of interest in the longer-term prospects for anything, (or too much attention to the proximate), which as active investors we find foolish, but it also creates opportunities for us.
Market Valuations Are Unusually Compressed
Source: Goldman Sachs Research as of 9/30/12. The index measured is a proprietary database maintained by Goldman Sachs of 1,400 companies which comprise nearly 90% of the MSCI All Country World Index. These companies were then divided into four quartiles based on cash return to investors. The graph above measures the first and fourth quartiles by a ratio of each individual company’s Enterprise Value to Earnings Before Interest Taxes Depreciation and Amortization (EV/EBITDA), which is a proxy for the market valuation of a stock. Past performance does not guarantee future results.
We once read an interview with Eugene Fama (who, along with Ken French, developed the idea that there is a “value” effect) where he was asked why value indexes have so persistently outperformed growth indexes. His answer was that value stocks likely outperform because they are riskier. Higher risk therefore commands a return premium in the form of a lower entry price. In other words, investors tend to regard faster growing companies as less risky, so they bid prices up, in effect lowering the future returns.
In the current environment, “safer” businesses are valued similarly to those regarded as less safe. In this unusual environment, I believe allocating more towards growth is a rational thing to do.