What's Your Prior?

The potential growth of Value investing and the astronomical value of Growth investing

June 19, 2020 Damian Handzy Season 1 Episode 2
What's Your Prior?
The potential growth of Value investing and the astronomical value of Growth investing
Chapters
What's Your Prior?
The potential growth of Value investing and the astronomical value of Growth investing
Jun 19, 2020 Season 1 Episode 2
Damian Handzy

Value investing – buying stocks that the markets price below their intrinsic worth – is a time-honored and proven investment strategy. So why has it done some poorly over the past five years and especially now?  Growth investing is relatively newer and has been on a tear. Is there any reason to believe it would slow down?

Mentioned in this episode:

Show Notes Transcript

Value investing – buying stocks that the markets price below their intrinsic worth – is a time-honored and proven investment strategy. So why has it done some poorly over the past five years and especially now?  Growth investing is relatively newer and has been on a tear. Is there any reason to believe it would slow down?

Mentioned in this episode:

Damian Handzy:

Which would you rather buy Space-X or Delta Airlines? No, seriously. I really want you to think about your answer. Would you rather invest in a company like Space-X, if it were public, I mean, or would you rather invest in an airline company? Take a second to really think about it. Now, if your answer wasn't something like "well, it depends on the price" then you're not thinking like a Value investor and the risk is that you might miss a really great opportunity to buy a good company on the cheap. Now, on the other hand, if your answer was to swing for the fences, regardless of price, you might be thinking like a Growth investor, but one who risks buying a very expensive stock that might never actually deliver. Value investing is all about identifying those companies that the market has underpriced for one reason or another waiting for the market to realize it's actually worth a lot more than previously thought, and sitting back and watching the price rise. Growth investing is all about getting in early on the next Google or Facebook before it takes off . Value investing as a strategy has lost a lot of money since shortly after the great financial crisis - it's been about 10 years. It's actually been one of the worst performing strategies in the past few years. It's supposed to do especially well in recoveries after market crashes, but it has been the single worst strategy and the post COVID rally. In this episode, we explore why Growth has done so well, why Value has done so poorly and whether or not Value has a chance of springing back.

Intro:

Hello and welcome to "What's Your Prior?", the podcast for the adaptable investor, with your host, Damian Handzy.

Damian Handzy:

Hi, I'm Damian Handzy and I'm the Head of Research and Chief Commercial Officer for Style Analytics. We provide factor and ESG analysis for professional investors. For this podcast episode number two, I had a couple of conversations about Value and Growth investing with two longtime colleagues, Timrudderow, co-founder, CEO and Chief Investment Officer of Mount Lucas management, and with his partner and co portfolio manager, David Asbell. At Style Analytics, we measure how “Value like” and how “Growth like” each stock is based on fundamental accounting data. Valueness is analyzed with metrics like the ratio of its book value to its price or with metrics like the amount of free cash flow it gives off. Stocks with a high ratio of theoretical value to price are Value-like because they’re lower price make the ratio higher. We measure how Growth-y a stock is with metrics like earnings growth or sales growth. Ranking stocks by its growth measures tells you how growth-like a stock is. At Style Analytics, we tend to measure how value-like and how growth-like a portfolio is to its benchmark, or to a peer group of other funds that it can reasonably be compared to. My guest Tim Rudderow has a complimentary way of thinking about Value and Growth stocks that I think is very intuitive. In addition to using fundamental measures like we do, Tim thinks about the timing of when the stocks deliver financial benefit to their investors and how interest rates impact those payments. Here’s Tim Rudderow:

Tim Rudderow:

Well , it's really kind of simple, right? Growth and Value stocks differ based on the timing of their earnings ... and interest rate markets allow us to normalize those between the two pieces. So let's take an example. Value stocks typically are mature companies that earn their money now and Growth stocks are relatively immature or rapidly growing companies that have the prospect of earning fantastic earnings in the future. Now, as interest rates fall, the value of nearby earnings actually declines and the value of tremendous forward earnings increases. So in a market where interest rates are falling, you're going to have a big premium put into stocks that may have great earnings sometime in the future and the uncertainty around those great earnings diminishes because they're , they're no longer quite as uncertain because of the discount rate. Think about it: I mean, if you're discounting it at a 5% interest rate, those forward earnings over 20 years from now, get depreciated quite a bit. But if you're discounting at 1 [%] or 50 basis points or even zero, those forward earnings are infinitely valuable relative to nearby earnings and the uncertainty that comes from nearby earnings. And we think that that's why in this environment, since like 2018, when rates were at a high and then just sort of precipitously declined, that's why we think Growth stocks have just demolished Value stocks over that period.

Damian Handzy:

All right . So Tim, why have value stocks done so poorly in the COVID period?

Tim Rudderow:

The value in Value stocks is the money they make now. And something like COVID, which sort of annihilates nearby earnings, kills Value stocks. So in order for Value stocks to do well, going forward, you're going to need a pretty fast recovery. And we've actually seen that here in the last couple of weeks where vVlue stocks have taken off, as people have said, Oh, maybe the recovery won't be quite as soft as everyone thought. We think that gamma here to recovery is incredible and Value stocks, historic opportunity. And I think that's exactly what's going to happen.

Damian Handzy:

So Tim and Dave, they talked to me a bit about gamma in Value stocks. The gamma that comes about, especially after a crash like COVID, which wiped away their ability to make short term earnings. Now, gamma is a term that usually is reserved for options. It's a nonlinear price response to some underlying change. In this case, what they mean is that deep Value stocks only need a small change in their underlying circumstances to take off like a loaded spring. They can rise spectacularly. Back to the question I posed in the episode opening, they talked about buying airline stocks like Delta and buying restaurant chains like Brinker International, which trades until the ticker EAT. Value stocks like these, they told me, were crushed by COVID because the market was acting as if no one would ever get on a plane again or eat at a restaurant again but that these were good companies that were caught in a bad situation. Tim described February as the golden age of airline travel and asked me when was the last time I saw an empty seat on a plane. I had to admit, it’s been a while. Back in February when Delta was trading around $60/share Tim said it was already a Value stock. After COIVD, was trading in the low $20’s. That would make it something like a Super-Value stock. Similarly, EAT, which owns restaurant chains like Chili’s, was trading in the low 40’s in February and then after COVID it hit single digits. It’s since come back to the mid-20’s. Now that the US and Europe are loosening our COVID restrictions, stocks like these should bounce back, rewarding their investors with that non-linear gamma profit. But while Value stocks have done poorly, Growth stocks have done really well these past few years, including in the post-COVID rally. Tim already explained earlier that growth stocks do really well in low interest rate environments because their promise of massive future earnings are discounted just a little to today’s value and so they look very valuable and we’ve been living through a long period of really low interest rates. I wanted to know if there was more to the story of growth’s, well, growth, than just the low interest rates. And here's Dave, Asbell

Dave Aspell:

The first thing, is it Growth stocks these past few years I've done incredibly well, not just from a return perspective, but actually executing their businesses without hitting too many potholes. They've been able to reinvest the cash plays at high rates of return, even at large size. And it's just an amazing feat and different from times past. It feels like. And also, yeah , the U S is home to many of the new global champions, these great businesses that are here have been able to expand with high leverage, into lots of new markets and done really well doing so. And they've also morphed a businesses into more subscription type revenue streams that are almost taxing oligopolies and in a world of lowered growth expectations, and then subsequently lower global rates. Investors value the predictability of these cash flows , particularly baskets, or these cash flows across different business sectors, more and more relative to the Valley names and to be Frank relative to bonds and credit as a real question, though, at what point are the names priced so high that they no longer make sense to hold at the end of the day, they are still stocks.

Damian Handzy:

Now Dave's comments about subscription revenue streams, and almost taxing oligopolies that had me pretty intrigued. Now Tim maintains that these tax like revenue streams of the big tech companies, coupled with a lax regulatory environment, have permitted them to simply dominate the stock market. And they've allowed those companies to gobble up just about every competitor. Why do Facebook, Google and Amazon have virtually no competition? Simple -- they've bought every possible competitor before it got too big to really challenge them. Furthermore, he says, earnings are no longer what really matter. What matters is just revenue growth. Even unprofitable revenue growth is okay. As long as there's growth, the stock price will rise because the market is discounting those uncertain but enormous future potential earnings by a tiny amount. So growth is the key to a high stock price. When you have an artificially low interest rate environment, along with little enforcement of anti competitive behavior. Dave walked me through a fascinating story of what he calls the "Doordash Pizza Arbitrage." Now doordash went to tremendous efforts to raise the number of orders going through their website. They use Google ads to get traffic to go to themselves instead of going to a popular New York Italian restauran, where they accepted that restaurant's pizza orders at a steep discount to the restaurant's own prices. Now the owner of the restaurant got wind of this and he decided to make some money on the arbitrage. A friend of his ordered several pizzas through doordash paying them $8 a pie, less than what the restaurant charged doordash for those same pizzas and the friends pocketed the difference. Now, why would doordash do this? Well? It gave them the appearance of strong revenue growth, which matters in the tech world and possibly even more than earnings. To me, that's very reminiscent of how companies operated back in the days of the tech bubble, when everyone was talking about the new economy and how things were different than how profits really didn't matter anymore... Now, in keeping with the theme of this podcast, I asked each of my guests, what would it take for them to change their minds about how and when value stocks might stage a comeback, and whether it's smart to put our money on value investing. Full-disclosure: Mt . Lucas runs a value investing strategy. So they've already put their money on this horse in the race, but I wanted to know what evidence they would need to see for them to believe that they might be wrong. Each one of them had an insightful answer first here's Dave Asbell

Dave Aspell:

Good question. What would it take to change my mind on value now for the record, I do appreciate growth investing what it is. I'm not blind to its merits by any means, but as I look at the Value names, we have at some point the dollars and cents, we'll just have to win out. If you have a good businesses at very low prices that are discounting terrible outcomes, it doesn't take much of a change to get a good return companies that continue to generate endings and cash flows that trade at very low valuations were just by themselves back, which can be a very powerful force over a few years.

Damian Handzy:

And I'll give the last word to Tim Rudderow, one of the smartest people I've ever met in my career in investment management.

Tim Rudderow:

If interest rates rise and Value stocks don't make a comeback and Growth rises along with the interest rates and the Value stocks don't make a comeback, I believe that calls into question every valuation model that we've been taught over the last 50 years in the development of quantitative finance. If that's the case, then discounted cash flows really are not meaningful anymore. It's all about momentum in that last 20% of holders and what they decide to do. And it becomes a game rather than investing.