Of the many surprises that 2020 has delivered to date, the one I find the most counter-intuitive and least explicable is the growing performance disparity between value stocks and growth stocks.
Through the end of May, the S&P 500 Pure Value Index (the subset of the S&P 500 Index exhibiting the strongest ‘value’ characteristics) had fallen by -32.3%,i while the S&P 500 Growth Index had gained +3.1%.ii This disparity would be extreme under any circumstances, but it’s simply astounding to me that it took place in conjunction with a severe equity market downturn. Bear markets are exactly the sort of uncertain conditions when we typically expect equity multiples to contract and when value stocks have historically outperformed, at least on a relative basis.
What’s driving the anomaly?
When we dig into what has driven this wide divergence between value and growth, a few contributing factors emerge:
- Sector attribution – The market’s downturn was not experienced equally across all 11 GICS (Global Industry Classification Standards) sectors. The Value Index happens to be over-weight the two worst performing sectors (energy and financials), while the Growth Index is disproportionately overweight one of the best performing sector (information technology). This sector imbalance may have accounted for around half of the disparity between the value and growth indices.
- Interest rate sensitivity – When taking the time value of money into consideration, falling interest rates are generally more favourable to growth stocks, whose cash flows are expected to be received further out in the future. It would be difficult to quantify exactly how much of the observed performance disparity was attributable to interest rate sensitivity, but it’s reasonable to conclude that the 1.50% cut to interest rates by the Federal Reserve was a contributing factor.
- Security concentration – Five stocks, Microsoft, Apple, Amazon, Google and Facebook, which currently make up 35% of the Growth Indexiii have collectively contributed all of the index’s year-to-date positive returns. We’ll take a closer look at these five outliers.
Table 1: The Beloved Tech Giants
(Please note: this table is best viewed horizontally on mobile devices.)
|Stock||MKT CAP (US$ B)||P/E (TRAILING)||P/E (FWD)||P/BV||P/SALES||DIV YIELD||2020 YTD RETURN|
|TOP 5 TOTAL||5,606||47.7x||33.7x||12.9x||6.7x||0.73%||+14.6%|
Sources: Thomson Reuters, NASDAQ, Yahoo Finance (as of May 29, 2020).
Prior to mid-2018, no freely floated company had ever traded at a market capitalization of $1 trillion. Today four of the five companies on the above list have exceeded that threshold. On average, these companies are trading at 48x their last 12 months earnings. Clearly the market has grand expectations for this group’s future earnings growth.
Some of the recent positive results from these businesses is at least explainable. As millions of people have been quarantined in their homes, online retailer Amazon and social-media platform Facebook have enjoyed significant advantages. More difficult to understand is the significant increase in valuations based on enhanced profitability that might endure for only a quarter or two. Retail shops will eventually re-open and people will eventually return to their normal routines, spending less time on social media. Yet these companies’ market valuations have risen by much more than the present value of these short-term earnings boosts.
Two of the above companies, Microsoft and Apple (the ones that actually pay dividends), have been long-time holdings in our US equity income strategy, based on their demonstrated ability to grow their dividends. However, the recent run-up in valuations has prompted partial sales of these holdings. It’s very unlikely we’d be buyers of any of these stocks at these valuations.
The market’s infatuation with these tech darlings is even harder to comprehend when compared to the unloved value stocks that are seemingly being overlooked. For less than 60% of what it would cost to own the aforementioned five big-tech companies, an investor could instead acquire every single one of the 107 companies in the S&P 500 Pure Value Index, and enjoy a much more broadly diversified portfolio with far more appealing valuation metrics.
Table 2: The Forgotten Value Stocks
(Please note: this table is best viewed horizontally on mobile devices.)
|PURE VALUE INDEX||MKT CAP (USD B) (a)||P/E (TRAILING) (b)||P/E (FWD) (c)||P/BV (b)||P/SALES (b)||DIV YIELD (c)||2020 YTD RETURN (a)|
|107 STOCK TOTAL||3,399||20.5x||15.4x||1.0x||0.5x||3.309%||-32.3%|
Source: S&P Dow Jones Indices, SPXPV
(a) As of May 29, 2020
(b) As of Dec 31, 2019
(c) As of Apr 30, 2020
Now, it’s quite likely that some of these value index companies (e.g. many in the energy sector) might be trading at depressed valuations for very good reasons, so we wouldn’t suggest indiscriminately buying all of the index constituents in a passive fund. But it’s also likely that some number of these businesses, by virtue of being out of favour and trading at discounted values, may offer higher return expectations and better downside protection than the tech giants. The challenge, of course, is knowing the difference. That’s why we favour highly-selective, fundamental, bottom-up, investment strategies that carefully identify which businesses represent good intrinsic value and can be bought at relatively attractive market prices.
Security concentration a challenge for active managers
When a small number of stocks end up accounting for a disproportionate weight in a benchmark index, this creates a unique set of difficulties for active managers. They know that it’s not prudent to make large concentrated bets on individual companies, and many mandates have constraints on the maximum weight that can be assigned to a single security or sector.
So it’s likely that most managers will maintain relatively underweight exposures to the tech behemoths. However, in a period where this subset of giant stocks has been the contributor of ALL of the benchmark’s performance, it becomes nearly impossible for an active manager who is prudently diversified to keep pace with the index’s returns.
Through the first four months of 2020, the median global equity manager in the eVestment database (which includes performance data from 924 mandates) had slightly underperformed the global benchmark MSCI World Index, losing -7.0% vs. -6.2%.iv Again this underperformance is rather counterintuitive, as conventional wisdom has believed that active management should perform relatively well during downturns. So far, this has not been a conventional downturn.
Fortunately, we don’t allow our investment philosophy to be unduly influenced by short-term anomalies. We have never been momentum traders who chase after whatever happens to be the hot stock of the moment. Instead, we identify managers who use security selection that strongly focuses on fundamentals and is reliant on well-researched assessments of a company’s intrinsic value. We expect that, over the long-term, prudence and patience will continue to be the path to investing success.
A number of factors go into successful investment management… identifying goals, making plans, setting expectations, applying conservative estimates, assessing risk appetite and tolerance, determining asset allocation, maintaining liquidity and diversification, and finally selecting managers and securities.
By putting all of these pieces into place ahead of any market dislocations, our clients know that no matter what surprises the market might bring – even a significant anomaly like we’re currently seeing with value and growth stocks – their plans are unlikely to be derailed. They have in place the resilience and flexibility to ride out the ups and downs, and remain well-positioned to achieve their goals.
If you’re interested in reading more Northwood investment commentaries released during the COVID-19 pandemic, and learning more about Northwood’s response to the pandemic, please visit Northwood’s Response to COVID-19.
i S&P Dow Jones Indices, SPXPV – Total Return through May 29, 2020
ii S&P Dow Jones Indices, SGX – Total Return through May 29, 2020
iii iShares S&P 500 Growth ETF IWV – Holdings at May 28, 2020
iv eVestment Global Equity Manager Universe – Gross return through Apr 30, 2020