Value Investing in the Digital Age

Executive Summary

Over the years, we have addressed the periodic performance swings between value equity strategies and growth equity strategies.   Differences have historically been cyclical in nature and often associated with the stage of the business cycle.  More recently, the pronounced outperformance of growth stocks over value stocks, now exceeding ten years, has led some to believe these differences go beyond the normal cyclical patterns and are now more a result of structural changes in the business environment.

Support for this thinking centers around the impact of evolving technologies and communication on the way businesses are run and how future growth opportunities are evaluated.  We take a closer look at this and other explanations below and find a logical case for the markets to continue favoring growth stocks.  Seasoned investors, though, will recognize the risk of throwing in the towel on value investing at just the wrong time.  We observe the cyclical changes that could restore value to favor as well as make the case that the principles of value always matter.

We conclude with conviction that value investing remains highly relevant, but we also grant that some things are different this time.  As such, we believe value investing will fare better in this environment by taking a more expansive approach in the search for valuable companies. Lastly, we discuss how we are assimilating these findings with our own quantitative and qualitative process in managing our Value strategy.


Introduction
The extended outperformance of growth strategies over value strategies is consistent with the current late-cycle, slow growth economy.  Investors typically bid up the price of companies that can grow on their own when the overall economy is not expected to provide much help.  Value stocks, on the other hand, have historically performed better in the early stages of a recovering economy.

The idea that there is more to the existing performance differential than the economic cycle is a worthy discussion and something we have been looking at closely.  It is highly relevant to the judgments we make in allocating client assets between value and growth strategies and to our own management of value investments.

The Case for Growth
Below we summarize several key points that support the view that the value/growth performance differential may have become more secular than cyclical, and what that means to our decision making process.

  • This view has called into question the effectiveness of many traditional corporate valuation techniques in the current business environment.   For example, financial measures focusing on a company’s tangible assets in determining value have been less effective in evaluating technology and service related companies where there is significant value in intellectual property assets.  Additionally, the increasing activity in corporate stock buybacks can have the effect of reducing a company’s book value, causing stocks to look more expensive based on this measure.
  • The extended period of low interest rates and weak inflation is being accepted by more as the new norm.  Lower interest rates increase the present value of a company’s long-term earnings stream, favoring growth stocks.  Low interest rates also make lending and investing less profitable for companies in the Financial sector, the largest component of value benchmarks.  Technological advances in oil and gas exploration have led to cheaper energy, undermining another large value sector.
  • The growth of Exchange Traded Funds (ETFs) has become a self-reinforcing support to the largest holdings inside broad market indices, currently favoring larger-sized growth stocks.
  • Growth stocks today are not as historically expensive relative to value stocks as they have been at growth peaks in the past, primarily because of the meaningfully higher earnings growth.  This does not preclude a shift back to value strategies, but the reversal might also be less significant than that of previous inflection points.
  • Earnings from large technology companies are now perceived as more dependable than the tech stocks of old, leading to higher values on future earnings streams. The gravitation of consumers to standard platforms has resulted in a “winner takes all” opportunity, creating a handful of mega-companies.  For example, Apple, Amazon, Google, and Microsoft are viewed by many as today’s blue chips, as their products have become fully integrated into everyday life.
  • Lastly, changes spurred by technological advances in communication have given all companies access to more efficient methods to reach prospective customers, impairing traditional advertising and undermining the brand-building strategies of many traditional companies. Access to powerful software is also helpful to start-up companies without having to finance huge up-front capital investments.

 

The Case for Value
These points make a strong case for growth strategies continuing to perform well.   However, the leap to headlines proclaiming the demise of value investing should give us pause.  Markets have taught us to be wary about calls for paradigm shifts and claims that “it is different this time” after a prolonged trend has been in place.

As we saw in the fourth quarter correction last year, value held up better than growth.  It is not unusual for higher valued stocks to decline more during periods of market weakness.  Style-driven performance can also be the result of sector strength or weakness and there could be dynamics that favorably impact financials, industrials, and/or energy, which would favor value strategies.  Increased regulatory risk remains a potential threat to the growth rates of the favored mega-cap tech companies.  There may also be a point where the markets recognize the “have-nots” have been too discounted relative to their fundamentals.

More importantly, this value/growth argument misses several key points.   At the most basic level, value investing means that price matters.  Regardless of investment style, most investment professionals follow some methodology to determine what a company is worth and whether today’s price makes that a good investment for the future.  The tools or parameters to make that determination defines much of what separates value strategies from growth strategies.

Value investing is also built around the belief that while the investment environment is bound to change, the tendencies of human behavior do not.  Investors will always be susceptible to emotion, herd instinct, and biases.  These natural influences will often lead investors to chase the stocks that have been performing best and inevitably push prices too high.

Respecting these time-honored caveats, while also accepting that some things are different this time, we take from this analysis the opportunity for value investing to look more expansively in how and where value is identified.  Our long-term belief in value investing is driven by more than a long overdue reversion to the mean.

Practical Application
Specifically, we recognize changes to an investment process can come from two sources – an ongoing reassessment of methods and tools, and adjustments due to secular changes in the investment environment.  While the latter is best done in moderation, being responsive to evolutionary change is appropriate.

Our process systematically evaluates the effectiveness of the different factors used in our models, as well as others we have access to.   What we have seen from our analysis is that the pure valuation component in our process has not been helpful over recent quarters.  We know factors are not supposed to work all the time, but consistent with a more expansive approach to valuation, we have run and tested different iterations of our model where our mix of valuation factors are more broadly balanced, with increased weightings on earnings quality and improving business fundamentals.

While retaining a clear value orientation, these adjustments, looking back over multiple timeframes, have produced what would have been better returns, on both an absolute and relative basis.  We had also noticed that our process had gravitated to smaller companies in its search for value, resulting in a universe of buy candidates with higher liquidity risk characteristics.  This revised model produces a deeper selection of larger, more stable companies.   We will be transitioning to this approach in the coming weeks.

As another important step, we have updated the qualitative framework we use to assess buy candidates.  This stage is now a more systematic, forward looking evaluation of a company’s broader fundamentals, serving as a second level confirmation.  It is designed to help us avoid stocks that are in fact value traps – companies that might look cheap from a historical perspective, but not so in reality due to deteriorating fundamentals.  Innovations brought about by technology have challenged value investors to separate viable companies from enterprises that fall intractably behind.

We believe these enhancements will enable our Value strategy to better assimilate changes in the environment with our existing beliefs and methodologies.   We are also mindful that there is no holy grail in the sense that markets are too efficient to allow any particular approach to outperform indefinitely.   Because the pace of change is not likely to slow, our ongoing practice of upgrading our tools and improving our processes becomes ever more important.