In our most recent webinar, Doug and I discussed HCM’s view that large growth equities are likely to underperform in 2021. We received some follow-up questions, so this blog provides a little more detail.
When Harry Markowitz first came up with the notion of Modern Portfolio Theory in the fifties, a new way of thinking about portfolios began to take shape that continues today. In its most basic form, it is why investors diversify between stocks and bonds. At a more sophisticated level that diversification focuses on a variety of asset classes and investment styles, including Value and Growth, to help balance the return expectations and risk exposure for any given portfolio allocation.
Investors’ preference for either value or growth stocks is cyclical. Recently, that favor has rested on growth stocks, which have dominated the market for the last decade. The 2020 crescendo was ultimately led by the biggest of the big: Apple, Amazon, Alphabet, Facebook, and Microsoft. HCM believes we’re beginning to see the start of a multi-year rotation into value stocks that will have a strong appeal for investors during the post-COVID economic recovery period.
No one can predict the future, of course, and past results are never a guarantee of future performance. But it is helpful to consider these two investment styles and how they have performed in past rotations.
What Are Value Stocks?
Value stocks are typically associated with companies that appear to be undervalued by the market or are in an industry or sector that is currently out of favor. They tend to do better financially as the economy improves. These stocks may be priced lower coming out of slow economies than might otherwise be expected in relation to their earnings, assets, or growth potential. In an expensive market, value stocks can offer relative bargains.
Established companies are more likely than younger companies to be considered value stocks. These businesses may be more conservative with spending and emphasize paying dividends (a favorite HCM attribute) in addition to reinvesting profits. The potential for solid dividend returns regardless of market direction is one reason why value stocks can be appealing in any market for clients laying the foundation for a financially secure retirement, especially in the current low-interest environment. An investor who purchases a value stock typically expects the broader market to ultimately recognize the company's full potential as the economic cycle progresses, which might push the stock price upward. This is the situation that we find ourselves in now as economic stimulus continues to flow and the COVID recovery of 2021 begins to take shape.
What are Growth Stocks?
Growth stocks are typically associated with above-average growth potential in difficult economies (consider the big five listed above). These types of companies might occupy a strong position in a growing industry, may be on the verge of a market breakthrough or be about to undertake an acquisition that will spark their growth regardless of what the economy is doing.
Growth companies are perceived as having the ability to grow revenues and earnings at higher levels, especially during difficult times in the economy. They may also place more emphasis on reinvesting profits than paying dividends (although many larger, well-established growth companies do pay dividends). Investors generally hope to benefit from future capital appreciation. Growth stocks may be priced higher in relation to current earnings or assets, so investors are essentially paying a premium for the growth potential. This is one reason why growth stocks carry greater risk for price volatility than value stocks.
Relative Performance of Value and Growth Stocks
At the start of 2015, large growth stocks traded at an average price of about 24 times their trailing earnings. They now sell at a price to earnings multiple of 45, meaning that for the same amount of earnings, today’s large-growth investors are willing to pay 87% more than they did in 2015.
Over that same time, large growth stocks appreciated in price by about 160%. Approximately one third of that increase can be explained by improved earnings while the balance is the result of investors being willing to pay an increasing premium for those earnings.
Looking at small value stocks, we see that their price to earnings multiple has actually declined modestly in the period since 2015. During this time, small companies have increased their earnings by about 30%. But their prices have only increased a bit more than 20%. To paraphrase Rodney Dangerfield, small caps “don’t get no respect.”
As the following chart shows, the relative performance of value and growth asset classes tend to be cyclical. The last 10 years have been a strong period for the growth style, but value stocks were stronger during the previous decade and the favorite sons often change when both the markets and economy go through difficult times. 2020 certainly meets that description. Therefore, we believe the stage for mean reversion is set.
Diversification and Portfolio Weighting
Because value and growth stocks tend to perform differently under different economic conditions, HCM believes it is wise to hold both value and growth stocks in your portfolio to help diversify investment risk. Moreover, actively over- or underweighting the portfolio’s exposure to these different asset types will help take advantage of the value trend as it takes hold. Diversification is a method that can help manage investment risk, but it does not guarantee a profit or protect against all loss. Managing risk is an important part of the wealth management process for portfolios that will be used to fund sustainable retirement distributions.
| Mike Hengehold, CPA/PFS MST RICP®
Mike is the Founder and President of HCM Wealth Advisors. Over the last 30 years, he’s provided financial planning guidance to a myriad of families to help them realize their financial dreams. Mike is an avid homebrewer and animal lover, and when he’s not at work you can often find him on the golf course working on his short game.