Dear Clients & Friends,
A previous colleague of mine would often say “Trees Don’t Grow to the Sky.” This great analogy means all things have their natural limits. Look outside at your local trees and you can see that the height and canopy vary greatly from a flowering dogwood tree standing at 20 feet tall to a great redwood at over 300 feet. The tallest known tree in the world is a redwood named Hyperion which stands at 380.3 feet. While redwoods are very tall with huge circumferences, they too have limits.
Equity markets have limits as well. Two established equity factors investors follow are Growth and Value. Growth often refers to investing in companies which have greater than expected or accelerating future earnings, and/or whose business is in an emerging or new industry. Investors who focus on growth investments anticipate that the revenues will translate into a higher stock price and in turn they will profit from the capital appreciation of the stock price over time. Growth stocks are often expensive and they tend to trade at a higher price to earnings (P/E) ratio or other valuation measure when compared to the broad market. This is due to investors expectations of strong future earnings. Tesla is an example of a current growth stock as it has a forward P/E ratio of 163, pays no dividend and is in the fast growing electric vehicle market. For comparison the S&P 500 index has a forward P/E of 22.
In comparison, Value investing traditionally involves investing in stocks which appear to be priced below their book or intrinsic value. Value investors believe the market over reacts to short term news flow both good and bad and stock movements are not representative of a company’s long-term fundamentals. Therefore, Value stocks are often “On Sale” and trade at low valuation multiples compared to the broad market, sector or industry. Additionally, these businesses often pay dividends so investors profit in a total return framework from both the dividends as well as stock price appreciation. Warren Buffett is one of the most well known value investors of all time. A current example of a Value stock is Intel, the semiconductor company. Investors have been concerned with their manufacturing issues and future products and therefore the stock trades at a forward P/E of 14 with a dividend yield of 2.1%. Again for comparisons, the S&P 500 index has a yield of 1.47% and a forward P/E of 22.
So why does understanding Growth and Value factors matter?
Market factors mean revert over time. Said differently, when factors move too far from their longterm average, they will trend back toward the average due to market forces. Below is a chart of the performance of Growth versus Value performance going back to 1979, when the value and growth indices were first created. When the blue bars are negative Value outperforms, and when the bars are positive Growth outperforms. The outperformance of each style moves in cycles and are linked to economics, monetary policy changes and valuations.
As you can see, Growth reached historic outperformance in the late 1990s as the tech bubble grew only to be followed by an equally historic Value outperformance until the great financial crisis of 2008. We have just recently witnessed another historic high of Growth outperformance driven by tremendous liquidity, zero interest rates and tech exuberance. History shows us that mean reversion will take hold. Each time this occurs, it is the result of a different catalyst such as the bursting of the technology bubble in the late 1990s or the mortgage market meltdown of 2008. What will it be this time? SPAC (Special Purpose Acquisition Company) euphoria bursting? Excessive risk taking sprinkled with large amounts of leverage? (We just witnessed the blow up of a $10B family office employing 10x leverage which resulted in billion dollar losses at a few investment banks.) Or perhaps it will be huge bouts of inflation due to runaway government debt? What ever it is, remember: “Trees Don’t Grow to the Sky!”
It is important to note that both Growth and Value factors have produced positive returns over time. Below is a chart if their respective performance through various regimes. Value has generated positive returns in every period below while growth does most of the time. Interestingly, Growth tends to be more volatile as you can see by the period returns while Value is more steady.
Predicting the cycles along with the length of each cycle is challenging. Therefore, portfolios need balance between both Growth and Value factors. Portfolios should have exposure to both and be diligent in rebalancing the exposures so one doesn’t overly dominate a portfolio. We began adding more Value in client portfolios last fall to balance out the exposure between Growth and Value. These cycles tend to last for years not months. Since the peak of the Growth/Value spread on September 2, 2020, Value has outperformed Growth by 18.1% thought April 6th 2021.
As we near or are at the peak in the Growth/Value spread, we often hear reasons or excuses as to why the divergence will last into perpetuity. “This time is different.” These are the four most dangerous words uttered in finance. From our experience, it is never different. “Trees Don’t Grow to the Sky.”
If you have questions about this piece or other finance related topics, feel free to reach out at any time. I am always happy to chat.
Best, Don
Copyright © 2020 Gervais Capital Management, LLC, All rights reserved.
Gervais Capital Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
Sources: KoyFin, Russell Indices (Russell 1000 Growth and Russell 1000 Value indices), Y-charts & Returns 2.0
"Trees Don't Grow to the Sky" -
Why you need to care about Growth AND Value Stocks.
