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Rekenthaler Report

The Bad and Good News for Value Investing

The strategy won't always be fighting a headwind.

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Fifteen Years Now
It’s no secret that value investing has struggled. When Vanguard introduced its  Vanguard Growth Index Fund (VIGRX) and  Vanguard Value Index Fund (VIVAX) index-fund series in 1998, history suggested that Value would lead, comfortably. Not so much. Value did indeed begin well, courtesy of the 2000-02 technology-stock crash, but over the trailing five-, 10-, and 15-year periods (through July 31), Growth Fund is ahead.

The bad news for value investing is that growth stocks’ victory appears rational. The reason for owning value stocks is not that the cheaper firms are superior. The financial markets are not so irrationally priced that good companies can be bought for less, while inferior ones cost more. The logic is instead that the outlook for growth stocks is too high, and that for value stocks too low.

Consider NFL win-loss predictions. If bets were not priced, few would pick the Cleveland Browns over the New England Patriots. (The last season that the Browns won more games than the Patriots, a white Ford Bronco headed the news.) But since costs do matter, the Browns could prove the better choice. Costs make the contest relative rather than absolute. Whether the Patriots outdo the Brown is immaterial. What counts is how the teams fare against the consensus.

In recent years, it turns out, growth companies have fared well against the consensus, thanks much. They were clearly superior at their time of purchase; they were expected to maintain that edge, by a certain margin; and they have matched, if not exceeded, those expectations. Thus, Vanguard Growth has thrived because its holdings have notched record profits. The stock prices have merely followed where the businesses have led.

The Price of Earnings
The evidence appears below.

Exhibit #1: Growth vs. Value: P/E Ratios
Relative P/Es, Vanguard Growth vs. Vanguard Value


Source: Morningstar Direct 

The graph portrays the relative price/earnings ratios of Vanguard’s Growth and Value funds, as calculated by Morningstar. For example, on the date of the final data point (June 2018), Growth Fund’s holdings traded at an average price/earnings ratio of 25.6, while Value Fund’s stocks registered 17.1. Dividing the former by the latter yields a ratio of 1.5, which is the figure plotted on the chart.

As you can see, relative P/E ratios have gone nowhere for 16 years. Growth stocks traded optimistically when the millennium began, got clocked for two-and-a-half years, and have since maintained their relative standing. The P/E evidence indicates that growth stocks have earned their way to their success, rather than being buoyed by higher investor sentiment.

Of course, there are some caveats. One being that four companies— Apple (AAPL),  Amazon.com (AMZN),  Facebook (FB), and  Alphabet (GOOGL) (that is, Google)—have determined much of Growth Fund’s results. Those four firms now account for almost 25% the fund, and have been the main reason why its portfolio has kept pace with earnings expectations. Another is that P/E ratios are but one method for measuring relative costs. Perhaps a different view would generate a different conclusion.

Price/Book Ratios
The first concern can be noted, but not answered. The global economy has changed so that a few technology companies now enjoy rampant success. Their near-monopoly status permits them to expand without encountering significant competition. Where that will stop, nobody knows. However, we can address the second item by testing another price ratio. Let’s see the picture drawn by relative price/book ratios.

Exhibit #2: Growth vs. Value: P/B Ratios
Relative P/Bs, Vanguard Growth vs. Vanguard Value


Source: Morningstar Direct

Similar, although not identical. Unlike the P/E graph, the P/B graph depicts Growth Fund’s relative price at its highest point since 2002. That is a warning light. However, that light is faint, as in the grand scheme of things, the relative P/B ratio remains compressed when compared with its New Era excesses. Also, one could reasonably argue that it’s acceptable for the relative P/B levels to rise, given that today’s leading growth companies have unprecedented powers.

The good news for value investing—you knew that could come, eventually—is that people naturally favor growth. Patrick O’Shaughnessy asks audiences, would they prefer to own Uber stock or a taxi medallion? Most opt for Uber. But as O’Shaughnessy reminds them, the answer should be neutral before price is introduced. The taxi industry need not boom for the medallion to be the better performer. All that is required is for taxis to retain their market share, or for Uber to hit a bump.

Football’s Lesson
I was reminded of growth’s attraction when talking with a co-worker about an NFL pool that he runs each year. (Yes, there was a plan behind that NFL analogy.) Participants “buy” several NFL teams, with success being measured by the collection’s regular-season and playoff victories. Each player receives the same budget, and the teams are priced according to their perceived quality. Logically, then, there would be no skew in the participants’ selections. One would favor this team, another that, and the idiosyncrasies would disappear in the wash.

However, that is not how the contest has worked. Historically, the players have preferred the top teams—the growth stocks, if you will—so that the pool’s entries contain more strong squads than weak squads. In response, the pool’s creator gradually adjusted his pricing mechanism, so that glamor teams such as the Patriots cost more than their expected value, and duds like the Browns less than theirs. Put simply, he stacked the game in favor of value strategies.

That should have led to a stampede, from the now-overpriced good teams to the now-underpriced weaker teams. It did not. There was some movement, but the overall pattern continued: The teams that were enjoyable to own, because they figured to win most of their games, and had excellent chances of earning playoff points, were selected more often than the also-rans. Consequently, those who favored the weaklings have won most recent pools.

My point? Growth stocks have been on a wonderful run, thanks to earnings reports that have surpassed even the optimists’ hopes. They will continue to perform well, as long as their businesses boom. However, the psychological reasons to believe in value investing remain intact. They will outlast current economic conditions.

 

 

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.