Is Value Investing Dead?

Investing has always been dominated by two schools of thought, growth and value. Buying companies with exceptional growth rates makes sense. After all, if the object of the game is to make money as fast as possible, concentrating on those few companies that can outperform their peers should give you the best chance of winning. The value school says, do it if you can but like everything in life, the future is unknowable and paying too much for anything, even the most promising investments, is a sure way to lose money.   

For as long as there have been financial markets the two schools have fought it out. Putting a high value on growth companies as the hot money piles in, only to see that enthusiasm fade when the curtain is pulled back. This has led to periods of significant outperformance of growth or value, but both schools have had their day in the sun. 

Except for right now. Growth investing has had one of the longest periods of outperformance in history and the question must be asked, is value investing dead? 

The chart of the last 10 years certainly looks like it might be true:

WHY GROWTH?

Why has the market been all about growth lately? For starters, bull markets always bring out the speculators, and hot money loves growth stories. Whether it was small cap tech in the eighties, internet stocks in the nineties or AI today, hot money goes towards the action.

Today’s growth stocks are also more highly concentrated than ever before. FANG, the magnificent seven or whatever hand full of stocks is in vogue today, represents a level of market capitalization and performance that makes the game seem like a no brainer.

Perhaps the investment climate has permanently changed in favor of large cap growth stocks? If AI changes everything and only a very few companies can afford to invest in it, then only Microsoft, Google, Meta, Apple, Tesla and Amazon will rule the world using nothing but Nvidia chips. If that’s the case forget about valuations and just buy them, because it’s the only game in town. Hell, even Warren Buffett bought Apple. Why fight the inevitable when it’s so obvious?

WHAT GROWTH?

Well, maybe not so easy for Tesla which is the biggest holding of all-star growth managers like Ron Barron and Cathie Woods, but it’s trading 40% off its July peak. Turns out despite assurance that Tesla wasn’t a car company but a technology company ready to transform the entire transportation industry, declining auto sales have dimmed investor enthusiasm. 

If there was one stock that looked like it was the heart of the big cap growth stocks it was Apple. Everyone has at least one of their devices and even though unit sales have been flat for a while, there was always China for growth, and the app store has fantastic margins. Except the trust busters in the US and Europe say those margins look an awful lot like they are running a monopoly, and the Chinese government says it would prefer its citizens use Chinese phones. 

Big cap growth stocks are being confronted by the reality that growth gets harder, not easier to come by as they get bigger. At some point, valuation matters, especially when growth is in the rear-view mirror. 

VALUATION MATTERS

We own a fair amount of two mega cap growth stocks that like most of our positions, we’ve owned for a very long time. We love them, but know that there’s a time to buy them, a time to hold them, and a time to trim them.   

We’ve owned Microsoft the longest. Starting out as PC operating system, it went on to dominate the fast-growing enterprise software market. When it looked like their best days were behind them, they pivoted to cloud computing, all while maintaining 25 to 35% profit margins and growing revenue by double digits. What’s not to like? 

Valuation for one thing. For the past fifteen years Microsoft has sold for an average price to earnings ratio of about 18x, about the same as the stock market. In 2020 when everybody pivoted to cloud, the P/E rocketed to over 30x. That seems high for a company expected to grow in the low double-digit range. We are happy to hold a position if it’s trimmed to a safe level, but to buy at this price is to believe that there will be no AI hiccups along the way. Maybe we take that risk at 18x, but not at 30x.   

The other stock is Alphabet (Google), which is selling at the lowest P/E of the group at ~23x. This may be reasonable given they have the most to lose if AI dents their advertising driven search business. At the same time, it’s still unclear where all the AI spending, including their own, leads to from an investment returns standpoint. Add in the fact that the justice department is breathing down their necks about anticompetitive search practices, and it’s clearly not a slam dunk despite the lower valuation. 

This isn’t just a problem with this group of big tech companies. Other classic growth companies in other sectors may have even more challenged valuations. Take Costco, which we’ve owned on and off over the years. It currently sells for a P/E of 45x. Before Covid, the average P/E was 25x during the previous 20 years. Costco is a wonderful business, but are its growth prospects that much better today than the previous 20 years?

The same can be said for Waste Management, Floor & Décor, Intuit, ServiceNow, AutoZone, Adobe and the list goes on. If a magic wand suddenly revalued Costco back to its normalized trading range, the stock would fall 45%. It may not happen, but any hiccups along the way would certainly cause investors to reassess the price they are willing to pay for the stock.    

MODERN DAY GROWTH INVESTING

Being a growth investor hasn’t always been this easy. After 10 years of negative real returns in stocks from 1969-1979, BusinessWeek ran a cover declaring “THE DEATH OF EQUITIES.” The first relief came from the new Nasdaq market for small cap growth stocks. Most of them never lasted long but from the trash heap came the likes of Microsoft, Intel and Apple providing great rewards to those who did their research.

Peter Lynch’s Fidelity Magellan Fund offered a way for the common man to participate in the bull market for emerging growth companies but followed the mantra of “growth at a reasonable price” making him a hybrid of the two schools. He was willing to make mistakes on growth companies because they could only go to zero while his big winners could double, triple and quadruple in value. Lynch held over a thousand companies in his portfolio but having a big basket didn’t stop him from beating the S&P by a factor of two during his tenure with the fund from 1977 to 1990.  

Meanwhile, a little-known value investor, Warren Buffett was quietly accumulating positions in great companies with stable businesses which he was able to buy with both fists when the growth bubble burst and brought down the whole market in the late eighties. Buffett was tutored by the father of value investing, Ben Graham, who taught him to be skeptical of promises and confident in good balance sheets. 

Back then, capital gains were taxed as ordinary income and that tax rate could be over 50% so rather than trading stocks, Buffett was buying Coke because he figured, correctly, that he’d never have to sell it.   

Both approaches to value investing worked well and while we will never know if Lynch’s style would have protected him from the brutal market growth stocks experienced in 2000-2005 timeframe, Buffett’s certainly did.  

WILL THE PAST REPEAT?

Our prior experience would argue that in the next major correction, value investing will again outperform. In the meantime, away from a handful of growth stocks, the rest of the market has barely budged while money has flowed in and out of the speculative plays. After the last few quarters, it’s fair to wonder if the market indexes are dominated by the big boys, shouldn’t our portfolios be too?  

The answer is simple: No, and for two reasons. The first is that every time the market has gotten overweight in one sector, whether it was tech, telecom, financials, or energy, it’s always been a good time to have less than a market weighting before the sector crashed. 

Secondly, out of the thousands of companies that can make good investments, an investor can choose a combination of risk, income and growth that meets their needs, not the index’s weighting. Pick the market you want to own, not the one that it feels like you must own because everybody else is doing it.    

We believe investors should own a diversified portfolio of growth and value stocks but right now, growth is expensive, and caution is warranted. That doesn’t mean we are predicting a market crash or even a correction, nobody can time that right. It does mean that we are perfectly happy to not own stocks priced for perfection when we can own great stable companies at about the same valuation they had a couple of years ago. We’ll wait for the correction, when it comes, to buy the companies promising to change the world. We’ll also find out if value investing is really dead or, as we believe, if it’s a prudent way for investors to protect and grow their assets for the long run.   

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}