Value stocks failed to hold up during the market correction caused by coronavirus while growth companies not only tended to make shallower losses in the crash but benefited the most from the following market bounce.
However, due to the 10-year underperformance of value stocks and the further dislocation that followed the Covid-19 correction, some argue that the conditions are ripe for their mighty comeback.
Jupiter Asset Management’s Dermot Murphy and Ben Whitmore believe that this could be a “historic opportunity” for value investors because of the record low valuations for value stocks and governments’ commitment to do ‘whatever it takes’ to shore up the economy.
They argued that growth shares have not been growing earnings unusually fast and low value shares haven’t been going bust more than usual. What they have instead observed is the widening of the valuation dispersion, or the valuation gap between most expensive and most lowly-valued stocks.
“One of the factors driving this extreme dispersion is that it is being pulled from both ends – expensive stocks have been getting more expensive at the same time as cheap stocks have been getting cheaper,” Murphy explained.
They highlighted that the valuation dispersion is even greater than at the height of the dot com bubble.
This view is shared by Dimensional Fund Advisors, the $454bn private investment firm, which noted that there has been a substantial widening of the price-to-book spread between value and growth stocks in the US.
US stocks’ valuation dispersion
Source: Dimensional, CRSP, Compustat
The investment firm argued that it is reasonable to expect securities with lower prices relative to fundamentals should have higher expected returns, in the form of a ‘value premium’.
“While value premiums may not show up every day, year or decade, we believe maintaining consistent exposure to value stocks is the most robust approach for capturing the value premium, regardless of current valuations,” it said.
Murphy and Whitmore also noted that after periods of value investing underperformance, value historically went on to outperform by 10.5 per cent per annum on average over the past nine periods of historical underperformance.
These nine periods included the Great Depression of 1932, World War 2, the 1970s oil shock, the 2000 tech bubble and the eurozone debt crisis of 2012.
They anticipate that the Covid-19 pandemic will result in “the deepest and sharpest recession on record” and said “a high degree of caution should be applied to balance sheet strength”.
They revealed that their £1.7bn Jupiter UK Special Situations fund added a new position in Booking Holidays (bookings.com).
“The collapse in global travel presented an attractive valuation point for the team to invest,” the managers said. “The company has a very strong balance sheet, with virtually no net debt, and a very flexible cost base.”
They said that a third of its revenue goes to Google to pay-for-search advertising, but that cost comes down dramatically when people stop searching – like now.
“In our estimation the company has the ability to survive for two years with zero earnings, so the team feels comfortable holding it on a multi-year view that travel activity will pick up gradually in future,” they added.
Murphy and Whitmore also said the investment case does not depend on international travel going back to normal soon because 45 per cent of Booking.com bookings have historically been domestic travellers.
Bookings Holdings share price over the past 5 years
Source: Google Finance
Commenting on the valuation dispersion, Stephen Yiu, manager of the £365m Blue Whale Growth Fund said investors need to take into account the market conditions during the tech bubble in 2000.
He pointed out that the Federal Reserve interest rate was 5 per cent during the tech bubble and peaked at 6.5 per cent. This is a stark contrast to today’s virtually zero interest rates, which has strong implications on expected future cash flows and therefore stock prices.
Whilst he agrees that the valuation dispersion is not going to continue to grow, and that there will be a reversion to the mean eventually, he said “it won't be now when we have zero interest rates and central banks are printing money compared to the tech bubble when interest rates were 5 per cent and nobody was printing money”.
One of the arguments many value investors have against growth stocks is the idea that earnings expectations are too optimistic and are pricing in endless growth. Amazon is currently priced at over 118 times earnings, for example.
However, Yiu believes Amazon, a major holding in his fund, still has room to grow its earnings. He points out while the US is the most penetrated market for the company, it is still smaller than Walmart in the retail space.
He highlights the opportunity for growth in Amazon Web Services, international markets across the UK, Europe and Asia, and the expansion of categories and total addressable markets.
“Sure, at some point it will run out, we are not debating that. If you are saying to me it's going to run out tomorrow or three years from today, I would say no,” he said.
“If you say growth is going to run out 10 or 20 years from today, then I would say maybe. But how far is it going to go up first before it comes down?”
Amazon share price over the past 5 years
Source: Google Finance
Comgest’s Alistair Wittet takes this idea a step further and argues that “if you find the right business with the right growth prospects, you can almost pay any multiple for it and make money”.
He pointed out that when Coca-Cola came to market in 1920 an investor could have paid 6,000 times earnings on the day of IPO and still would have outperformed the S&P 500 index.
He said: “The reason is Coca-Cola is delivering sustainable earnings growth over pretty much a century.”
He emphasized the importance of focusing on the long term: “If you’re buying a business because you see growth over the next two to three years, you're unlikely to make a huge amount of money off that.
“The market has already priced for that – the market has a time horizon that means that sort of growth is normally well priced.”
Wittet said where investors can find huge anomalies is in the long run, “which is why all of our work is really spent trying to research the long-term prospects of our companies, because where the market tends to be surprised is in years 10, 15, 25 or 30”.