Over the past several years, investors in growth stocks have been handsomely rewarded, compared to their peers who have largely favored value stocks. Typically speaking, growth stocks are characterized by high Price-to-Earnings (P/E) and higher Price-to-Book (P/B) values. Investors who build portfolios around growth are banking primarily on capital appreciation. The FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) are typical examples of growth stocks.
However, based on valuations of some of these stocks, it might appear that there is better value ahead in value stocks, compared to growthier names. Let’s explore that thought in greater detail.
Making The Case
To illustrate what we’re talking about, let’s take a look at a growth name like Amazon.com, Inc. (AMZN). At the time of this writing it is trading at a Trailing P/E of 159.40x, and a Forward P/E of 79.33x. Those are rather steep valuations by any standard. However, it has a growth profile (as exhibited by its 5-year expected PEG Ratio) of just 2.51X.
Over the past 1-year, the name has run up by over 105%, making investors in AMZN very happy. This is a significant achievement for a stock that does not pay a dividend, but promises a lot more in price appreciation.
Let’s take a look at one other growth-stalwarts, Facebook, Inc. (FB), before laying out our case for value. As of writing, FB is trading at a Trailing P/E of 27.19x, and a Forward P/E of 21.07x, with a 5-year expected PEG Ratio of just 1.10x.
The point that’s being made here is that with PEG Ratios between 1 and 3x, there’s not enough growth predicted for such growth-oriented names to justify the valuations that they are currently trading at. For example, fundamental analysts will tell you that PEG Ratios of 1 (or closer) represent as much a value proposition as a growthier one. Yet, based on current valuations, investors are willing to pay a significant premium for growth names.
Furthering The Case
We’ve seen so far that growth investing seems to be rewarding investors pretty well over the last while – so why bail from a “good thing”? Well, to further our case for value over growth, let’s take a broader look at how markets are performing – much broader than just FAANG stocks.
To further our base case that value is likely to outperform growth in future, lets take a look at the Russell 1000 Index (^RUI), and its components – the Russell 1000 Growth Index (^RLG), and the Russell 1000 Value Index (^RLV). Components of the 1000 names in the ^RUI represent a value segment of the market – those that are slow-and-steady earners and growers (as indicated by the ^RLV), and those with rapid growth profiles and high PE valuations (as represented by the ^RLG).
From the graph above, we can clearly see that, over a 5-year time horizon, components of the ^RLG index have handily beat their peers from the ^RLV index. Even the overall ^RUI index appears to be performing better than the value-sub-index. So, the question still remains: Why should investors trade horses now, and jump from what’s clearly working, to something that doesn’t seem to working all that well.
The answer: Momentum!
While the 5-year view indicates that, over a longer-term, growth investing has certainly been favorable to investors, a deep dive into the shorter-term performance provides us some insight as to why that growth might be running out of steam.
If we take a look at ^RLG and ^RLV over multiple time periods, we can see a definite pattern developing. While, on an absolute basis, ^RLG is still higher than ^RLV, the delta between the two indices is narrowing. Over a 5-year period, the gap between the two indices was more than 50%, but over a 1-year horizon, that gap had dropped down to just 15%. The past six and three-months have seen the performance gap further decline to 7.6% and 3.00% respectively.
The moral of the thesis: Growth investors may have enjoyed a good run for the last several years, but the numbers seem to indicate its time for value investors to share the limelight!
So, if value plays are expected to dominate in the coming future (weeks, months, quarters – no one can predict, but it’s poised to happen!), what names should investors rotate into?
Our preference would be to pick steady-eddy names that mostly offer increasing dividends, and are poised to benefit from a strong and growing economy. The value play that we like include names like Bank of America Corporation (BAC), United Rentals, Inc. (URI), Pfizer Inc. (PFE), Cisco Systems, Inc. (CSCO). Notice that all of the names displayed in the chart above have Forward P/E valuations in the high-single to low double-digits. A portfolio comprising these four names would have delivered a steady 34.37% return over a 1-year period – but unlike many growth plays, you’d also have been paid (dividends) by most of these names as they continued to add value to your portfolio over the long run.
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