Pick Your Pivot Point
Growth has the Momentum
For this KnowRisk Report, we are undertaking some research on the pivot points between the Growth and Value investment styles that has been swinging back and forth like a pendulum for decades. When will it swing back to Value? No one knows. However, if the game is to buy low and sell high, we do know how to tell what is low.
Since the end of 2016 through third quarter 2019, the Russell 1000 Growth Index has grown explosively by 58.12%, while the Russell 1000 Value Index has limped along returning a modest +22.8%. This is one of the longest sustained “growth” cycles since the Dot-Com Bubble, although that period saw an even bigger performance differential between growth and value.
T.S. Eliot wrote: “This is the way the world ends, not with a bang but with a whimper.” Value cycles, however, are the opposite, typically ending the growth cycle with a bang. Growth cycles typically last an average of 20 months, and it is darkest for value before the dawn. The charts on the next page show the current cycle, which has several characteristics in common with past cycles including the financial crisis in 2008, and the tech bubble in 2000. The early 90’s, 80’s, and 70’s saw similar patterns. The yellow line in the graphs signifies the pivot point.
The portfolio managers at the value style company, Lyrical Asset Management, have identified three common factors to the beginning of every value upcycle/ending of every growth cycle, which they describe as being similar to an earthquake. For the last decade, the underlying companies in this manager’s portfolio have grown their earnings an average of 7.6% a year. That same stat for the companies in the S&P 500 is 5.9%. Surprisingly, even with the higher earnings growth rate, their value stock portfolio Price-to-Earnings (P/E) Ratio has compressed to 8.9 while the S&P 500 PE Ratio is 17.1. (See graph on next page) On a price to earning basis, that is almost a 50% off sale. Value stocks are cheap. Will they remain cheap?
The one thing in common in all of the previously examined scenarios is that they each had the successful conclusion of a “reversion to the mean”. What if this time is different?
“This time it’s different” / Famous Last Words
Previous growth cycles have included dramatic P/E multiple expansion by some of the biggest names in the index. That is, the price and weight of these companies increased faster than their underlying earnings. Recently, FAANG stocks have grown market cap from 1% to 10% of US equity market, but have grown profits from 1% to 12% of US equity market. Since profits have grown faster than valuation, over-valuation concerns are muted. The “top heavy” nature of the stock market has also changed. The percentage of the total market represented by the five largest companies, as high as +40% in the past, is at the lower end near 10% today.
Others argue that technological disruption might have turned value stocks from cyclical losers to secular losers. Previous periods of lagging returns for value stocks were attributed to temporary disruptions. Today, the rate of technological change is greater than ever and entire industries are being re-imagined for the future. Amazon, eBay, and other online shopping have caused a huge secular decline in retail. The energy sector, dominated by large fossil fuel companies, is under attack from green innovators, shale innovators and politicians. Even legacy financial companies have a reason to be fearful as fintech companies have risen from zero to take a 40% share of the US personal loan business. Quicken Loans now ranks among the nation’s top mortgage lenders. The areas of disruption are so large that there are entire investment funds built around investing in these disruptor companies. If valuations grow larger and faster than earnings, this area could
also be the creation of the next “earthquake” moment for value. However, at present, growth stock valuations remain within the moderate zone of historical levels. One growth manager, Polen Capital, summarizes the situation: “Hoping value stocks will outperform because they have not in so long ignores that many of the growth stocks we hold today have been outperforming because of the underlying business fundamentals and not because they are classified as “growth.” They are typically well positioned in attractive markets that they themselves have often created, while many of the most commonly mentioned “value” stocks involve businesses that are moving in what we believe is the wrong direction. Clearly an overgeneralization, but hopefully our point is clear”
Pick your Pivot Point
With solid arguments behind both growth and value philosophies, which way should we turn? Will we see a tipping point that ends the growth cycle like an earthquake? Will the growth market continue into the secular horizon? At Equitas, we always prefer to bring discussions back to the fundamentals, and in our experience recessions end growth cycles. Today, consumer confidence has dropped along with global manufacturing to near neutral levels that are neither expansionary nor contractionary. Trade policy uncertainty has correlated with most of the recent volatility in the market, and in our view may largely determine the path going forward. While we were encouraged by the latest revelation that the USA and China tentative agreed to a stage one deal, anything can happen. In an environment dominated by passive index funds, active managers have greater room to pick up strong companies at attractive valuations. Will it be growth or value? Pick your pivot point! For more information, please contact Equitas Capital at 504-569-9600.
In 2002 Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.
Disclosures and Disclaimers:
Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.
Equitas Capital Advisors, LLC is registered as an investment advisor with the U.S. Securities and Exchange Commission (“SEC”) and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.
Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.
Charts and references to returns do not represent the performance achieved by Equitas Capital Advisors, LLC, or any of its clients.
Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.
All investment strategies have the potential for profit or loss. There can be no assurances that an investor’s portfolio will match or outperform any particular benchmark. Past performance does not guarantee future investment success.