Benjamin Graham was one of the forerunners of ‘value investing’. The investment style characterized by investing in securities excessively punished by the market and with great potential for revaluation ahead of that penalty. I have always said that successful investing requires “patience to wait for opportunities that may be spaced years apart”. However, he added, once such moments arise, it also requires the discipline to stick with them as it develops over time. And that is a point that today’s investors might remember.
After waiting a grueling 15 years for the value to begin to outpace growth, something that began in early 2021, some investors are already turning their backs on the fledgling rally. As interest rates have normalized, conversations can be heard in which people wonder aloud if they have missed the rebound.
Funds flow data supports this trend away from value for retailers. In November, the ETF with the biggest net inflows was the Invesco QQQ Trust, which owns the fastest-growing stocks on the Nasdaq, almost half of which are technology.
By contrast, the ETF with the largest individual outflows in November was the Vanguard Value ETF, although the month of December did show a bit of a reversal of these flows. All in all, these are surprising trends considering that the QQQ is down more than 30% over the past year ending December 31, 2022, while the Vanguard Value ETF was only about 2% over the same period.
The same thing happened shortly after the dot-com growth bubble burst in 2000, when the value of small-caps began to eclipse that of large-caps. Barely a year after the late-tech wreck, some investors who hit the value cycle assumed they had missed their window and opted to bet on big stocks, which they incorrectly assumed were bargains just because they were priceless.
That was a losing bet. Those who invested in stocks of companies found in the Standard & Poor’s Information Technology 500 index lost a year after 2000 by 29% cumulatively over the next five years. By contrast, those who remained patient and continued to invest in small-cap stocks gained 89%, according to the Russell 2000 Value Index from early 2001 through 2005.
“For today’s investors wondering if it’s too late to accept value, that experience should offer an important clue,” Atlantic Capital comments in a recent note. “Growth and value tend to take turns leading the market, but cycles often last for years, not days,” she adds.
An important point is also highlighted: value investing and “buying on dips” are not the same thing. Just because popular growth stocks that were once market darlings have dropped considerably from their peak doesn’t mean they’re cheap. Or cheap enough to be worth buying. They may have more room to fall.
a review to the past
Looking back at the year 2000, investors who bought growth stocks that looked like they had capitulated on dips weren’t thinking like true bargain hunters. As Graham said, the smart investor focuses on fundamentals and is always mindful of building a margin of safety into his strategy.
In late 2000, small- and mid-cap stocks were still more attractively priced than large-cap growth, even after the technology’s big losses. For example, the earnings return for the Information Technology sector of the S&P 500, which measures the earnings per share generated by an investment divided by the price per share, was 3.1%. It was well below the 7.4% earnings return for the Russell 2000 Value Index.
“Perhaps if the earnings yield from the technology had been higher than the interest rate paid for ‘risk-free’ assets such as Treasury bills, they might have had some appeal, but that was not the case,” they say from Atlantic Capital. “Tech’s earnings yield in December 2000 was 2 percentage points lower than what Treasury bills paid; that is, its market risk premium was negative”, they delve.
Why would someone bet on an investment that exposes them to greater market risk when they could earn more with risk-free cash? This is an important point to consider as we emerge from a prolonged period of abnormally low rates.
Impatient investors contemplating buying growth stocks at knockdown prices need to understand that the situation reflects the dotcom bubble era. The market risk premium for technology stocks is again negative.
Meanwhile, with earnings returns of 10.5% and 7.4%, respectively, stocks in the Russell 2000 Value and Russell Midcap Value Indexes look far more attractive than large-cap tech stocks, even after the dip. of 2022.
“This emphasizes why investors should avoid acting on instinct and instead operating on fundamentals, especially at a time when market risks are on the rise,” these experts conclude.
