Value or growth stocks? Analysts are always touting one over the other, against the backdrop of shifting economic and financial conditions. Value stocks are generally favoured when, say, uncertainties/risks are elevated or during recessions, when we are advised to be more defensive.
On the other hand, investors generally pivot to growth stocks, which they expect to outperform, during boom times, bull markets or when interest rates are falling. There are a vast number of funds, both active and passive, that are dedicated to investing primarily in value stocks or growth stocks or some specific mix of the two. Exchange-traded funds track the many underlying indices, focused on either value or growth stocks, created specifically for such purposes.
Over the past decade, however, value stocks have significantly underperformed growth stocks. For instance, the chart shows the ever-widening divergence in returns between component stocks in the Russell 1000 Value Index and Russell 1000 Growth Index. The persistent underperformance has even led some to posit that value investing — the time-honoured strategy embraced by some of the world’s greatest investors the likes of Benjamin Graham and Warren Buffett — is failing. Is it?
Value investing is the strategy of buying stocks that are perceived to be trading at material discounts to their intrinsic values. The rationale is that investors will earn outsized returns when the market realises this undervaluation and the share price eventually catches up.
We are students of value investing. And we definitely do not think the strategy itself is failing. Rather, we think many people, including analysts and self-professed experts, are either confused with the term “value” or have forgotten what it means. We see articles explaining at length the differences between value investing (buying value stocks) and growth investing (buying growth stocks) — and finding reasons for when and why one group outperforms the other.
In fact, the concept of value investing is applicable to all stocks. In other words, growth and value are not mutually exclusive. The key determinant is whether current prices are below intrinsic values. The real problem lies in how analysts define intrinsic value.
Intrinsic value is, and always will be, the sum of future cash flows discounted by the cost of capital, adjusted for risks. However, analysts have taken up many short-forms (simplified valuation metrics) to derive intrinsic values — whether for ease of calculation and communication or some other reasons — such as price-to-book value (PB), price-to-earnings (PE), price-to-sales (PS) and so on.
One of the most commonly used metrics to denote value is PB — including the definition currently used for the Russell 1000 Value Index. Purportedly, the lower the PB ratio, the cheaper the stock is relative to its intrinsic value and, accordingly, the better the “value”. This is wrong — tangible book value is based on historical accounting while intrinsic value is derived from discounting future cash flows.
In other words, historical book value is not intrinsic value. At best, it gives a guesstimate of intrinsic value — based on expectations that capital investment in net tangible assets (such as plant and equipment) is correlated to the capacity to generate future earnings and cash flows. This has worked reasonably well, in the past. However, it is woefully inadequate in estimating the intrinsic value for tech stocks.
Tech companies, in general, have far lower capital intensity vis-à-vis, say, manufacturing, industrials, utilities or energy businesses. They spend little on capex for plant and equipment and far more on intangibles such as R&D and intellectual property (IP), and for some, for customer acquisition and marketing blitz.
A significantly larger portion of tech costs goes to salaries to attract and retain talent. All these result in comparatively low tangible book values for tech stocks, which then translate into higher PB valuations — but that tells us exactly nothing about whether the stocks are “cheap” or “expensive” relative to future cash flows and intrinsic values.
Value investing is not about picking stocks with the lowest PB. And to suggest that the strategy is failing due to the poor choice of valuation metrics is quite simply nonsensical.
In fact, with the evolving accounting standards — and overly ambitious objectives of the accounting profession — such traditional valuation metrics based on financial statements may not even tell us much about the actual profits, cash flows or assets and liabilities of the company. The usefulness of reported financial numbers, sometimes based on arbitrary decisions, is falling even as distortion and ambiguity grow. Hence, we think the most popular and commonly used valuation metrics based on reported financial numbers will, increasingly, be less and less relevant or reflective of future cash-flow generating ability. That said, there is no doubt that highgrowth stocks, primarily tech, have far outperformed over the past decade — against the backdrop of very low and falling interest rates. It is maths. To recap, intrinsic value (V) is equal to the sum of discounted future cash flows (CF);
If we assume r (discount rate) and g (growth rate) are constant;
We calculated the intrinsic value for every $1 of cash flow per year growing at g rate and discounted by r rate (assuming both remain constant), all else being equal, in the table. When the cost of money — the discount rate (interest rate adjusted for risks) — is low, as it has been for more than a decade, value becomes extremely high (to infinity) even at moderate growth rates.
Of course, in real life, g is definitely not constant and likely, neither is r. The typical growth rate for a business over time is shaped like an S. This is the so-called S-curve, where growth starts off slow, then hits a period of growth spurt before gradually levelling off as the business matures. As we have written before, the S-curve is also not static — most businesses will create new cycles of growth over time.
The growth in future cash flows depends on the total addressable market (TAM), future market share and gross margins, all of which are dynamic and evolving. Indeed, rapid technological advancements could disrupt entire markets and upend any assumption and forecasts made today. This is why there are gaping differences in valuations, especially for tech stocks.
Take Tesla as an example. Its market cap of US$1.2 trillion ($1.63 trillion) is more than the combined market cap of the world’s 10 biggest legacy carmakers (which totals approximately US$976 billion). The market for cars is mature and a known TAM.
Is it probable that Tesla can win all the market shares of these top carmakers today, to justify its valuations? We think not. But a Tesla super bull could justify its current valuations — if he believes the company’s TAM can expand beyond the car market to, say, ride-hailing services, delivery and logistics, and indeed, any number of future services that could be provided in a car connected to the internet. He could be right, and the future car is a smartphone on wheels. Perhaps Elon Musk can even expand Tesla’s TAM beyond connected cars into satellite internet access and communications (Starlink) globally.
But maybe Apple, long speculated to be building its own electric vehicle with full autonomous capabilities, will disrupt all current expectations of Tesla’s dominance. Or perhaps the future will turn out to be a scenario yet to be imagined.
Herein lies the biggest challenge with indexing (and indeed for all investors) going forward — when simplified, short-form valuation metrics no longer adequately capture the variables required to accurately measure intrinsic values. And if so, surely the funds tracking these value indices too are unlikely to outperform. Digitalisation will make the task of identifying real “value” stocks using traditional metrics near impossible. And quite honestly, it is these challenges that continue to motivate us to study and write this column.
The Global Portfolio declined 1.5% for the week ended Nov 24. Alibaba Group Holding was the biggest loser, falling 20.1% in the worst one-week for the stock since listing in 2014. The selloff follows a flurry of analyst downgrades on the back of weaker-than-expected earnings results as well intensified regulatory concerns. Travel-related shares, included Airbnb (-9.7%), The Walt Disney Co (-3.8%) and Mastercard (-5.3%) were buffeted by a fresh wave of Covid-19 cases and tightened restrictions across Europe. The top gainers for the week were Builders FirstSource (+6.4%), Apple (+5.5%) and Home Depot (+4.4%). Last week’s decline pared total returns since inception to 68.3%. Still, this portfolio is outperforming the benchmark MSCI World Net Return Index, which is up 62.7% over the same period.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
Photo: Bloomberg
