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Over the last decade, growth outperformed value. With the recent resurgence of value investing, should investors be looking to follow the market rotation or is there an alternative to this binary choice?
The Mackenzie Bluewater Team, known for its “conservative growth” investing style, has generated long-term wealth for its clients for over 25 years. We sat down with the team’s chief economist and portfolio manager, David Arpin, to understand the current market rotation and why, contrary to popular belief, “growth” and “value” are not fundamentally in conflict.
What’s your perspective on the “growth vs. value” debate?
That the “versus” has never made any sense to us. There are only three ways you can make money in a stock. The valuation can change (“value”), the underlying item you’re looking at (such as free cash flow, sales, earnings, book value) can increase (“growth”), or the company can pay you out internally generated cashflow in a dividend or buyback (“income”). A company can simultaneously be value, growth and income – the best investments usually have at least two out of three. A company can also be none of the above: low growth, no income, expensive. There’s no inherent conflict between value, growth and income.
It’s useful to think about the history of value and growth. Classical Ben Graham value was about finding “unloved and unfollowed” companies and in the 1920s and 1930s you clearly could find them (based on numerous examples). With the rise of professional investors, it became much more difficult, but was still possible. However, the combination of the internet and massive computing power focused on capital markets has pushed the search into the fringes of the market. One could very reasonably argue that there are unfollowed and badly mis-valued micro caps in emerging markets. The same argument doesn’t really hold for constituents of the S&P 500 Index, which is combed over every second by artificial intelligence programs. Early in our careers, if you wanted the annual report for a company you had to call them up and have them mail it to you. Now, the moment a 10K (or any other) filing hits Edgar, it’s automatically and nearly instantly dissected. Nothing is unfollowed, and since computers don’t have emotions, “unloved” is likely going to be unusual and short lived.
Classical growth came from Phil Fisher and was based on his observation that companies like Motorola, which was a growing company in a growing area, could provide high compound returns over an extended period. At the time, this was a huge insight. It was popularized by Warren Buffett and Charlie Munger in the 1970s through the 1990s and is now fundamentally understood and heavily discounted by the market. Companies that are viewed as long-term compounders tend to trade at significant premium valuations which offsets much, or all, of the benefit of their growth. In other words, finding a “great company” doesn’t imply finding a “great investment” anymore.
Essentially, classical value and growth are interesting history (fundamental investors need to know about them) but aren’t as meaningful in a world of massive information/ large computing power. They’re just too simple an arbitrage.
Hasn’t the recent market rotation been about a switch from growth to value?
It shows up that way, in terms of market indices, but that’s more an issue of index construction. The rotation has really been from safety to cyclicality and from deflation to inflation, which make perfect sense in a world that’s heading towards post-pandemic reopening.
In some ways, the “growth vs. value” framework is a result of an index methodology of shoehorning companies into S&P 500 Value and S&P 500 Growth. That’s done with:
Price-to-book, coming from Fama and French in the 1970s, which made lots of sense in an industrial world but doesn’t make much sense in a brand/IP dominated world.
Price-to-sales, which would make a huge amount of sense if companies all had similar margins. Unfortunately, they range from near zero to 35% or more. Low margin companies (discount retailers, for example) will always appear “cheap” on price-to-sales; high margin companies (software) will always appear “expensive” regardless of valuation.
Price-to-earnings, which has all kinds of well-known problems (which I think most investors try to get around through some “cashification” methodology), but we’d say is the best of the three.
Index construction seems to have created an odd tilt problem in the value index, where it’s dominated by a handful of industries seemingly regardless of valuation. High book value and/or lower margin businesses will tend to be classified as value even if they trade at what we think of as very high valuations in a market with a large presence of industries like software, with low/no book value and high margins.
The way we think about the value and growth indices is that they’ve ended up as (fairly poor) proxies for cyclicality. The high book value/lower margin industries (for whatever reason) seem to predominantly be areas that are procyclical (banking and energy, which combine to over half the S&P 500 Pure Value Index). The growth index is more mixed right now, with heavy weights in companies that are less GDP sensitive. As a result, in our opinion, the relative performance of the value and growth indexes doesn’t really have much to do with “value” and “growth” – it’s quite clearly about cyclicality.
Is this rotation the beginning of an extended cycle, similar to what we saw in the 1970s or the 2000s?
In our view, for that to happen, businesses in the value-oriented sectors/industries will need to see improving results, beyond the short-term rebound post-Covid. This is what happened in the prior large and long value cycles where the value-oriented industries had a long cycle of growth. For example, commodity prices increased massively from 1998 to 2008, when oil went from $11 to $145 per barrel, and the market moved from a view of abundance to fears of peak oil supply. This, combined with the US housing/financial bubble, drove the substantial value outperformance during the 2000s. The 1970s were a similar story, with rising inflation and extremely strong commodity prices (oil and gold were both up over 1,000%). Companies in those areas showed strong growth over the decade and were re-valued accordingly.
If this decade turns out to be the one where we turn the corner on secular stagnation, and global economic growth is strong (which implies higher commodity prices and a steeper yield curve), then the value index should outperform the growth index regardless of valuation; the businesses will do better because they’re pro-cyclical and will show strong earnings growth. If it turns out that post-rebound we slip back into lower growth stagnation (which implies it’s more of a demographic/disruption based problem) then we’d expect the growth index would do better, even though that’s a scenario where, ironically, global GDP growth would be noticeably lower.
What makes this decade more difficult to call than the 1970s or the 2000s is that we’re in a period of extremely rapid technological change. We appear to be moving into a global energy transition, shifting away from fossil fuels and towards renewables. For example, the global transportation sector is expected to increasingly adopt electrification, while there is a rising focus on the greening and mass deployment of hydrogen as a broadly used fuel. This is expected to have a large, but mixed, impact on commodity demand, increasing demand for some commodities while sharply decreasing demand for others. That’s different from the 1970s and, in particular, from the 2000s, where the rise of China drove massive demand for all commodities. As always, we continue to look for investments that will benefit from these evolving secular trends.
We’d just say that in general value “versus” growth is something that we’ve thought about, but really don’t think is all that important or useful. At Bluewater, we always try to incorporate all three components of value, growth and income into our investment style as perhaps most fundamental investors do as well.
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