"When things are easy, I hate it." — Ernest Shackleton
“Optics” are an important phenomenon in the investment advisory business. How things look from the outside matters to advisors and, oftentimes, to their customers. Many decisions are made with respect to optics -- because a carefully cultivated image and reputation of an advisory business can lead directly to new clients. Growth from new clients is how advisory owners increase their own income and net worth. Yet optics-based decision-making can often conflict with doing what is right for clients.
Optics explains crowded trades, herding behavior and momentum investing. Therefore it explains today’s appeal of ‘growth’ stocks. Many advisors want to own the same popular investments that are “working” because they know that their clients (and prospective clients) don’t want to miss out on big returns. Advisors want to appear smart, trendy, cutting edge, energetic, with-it and in tune with investing trends.
Many advisors don’t want to own mundane, unsexy, non-headline-grabbing, unloved or God-forbid, “challenged” businesses because their clients don’t want that. All the action is in the high-flyers and the stocks that have done well -- recently. That’s where most advisors focus their efforts. Does investing in popular stocks work for clients? Not over the long run.
According to Grant’s Interest Rate Observer, growth stocks are “desirable because [they are] fast-growing, big, cash- generative, popular, world-beating and transformative.” They carry high multiples and are newer businesses, have new technology and high revenue growth. Growth companies favor market share over profit. Conversely, value stocks are “desirable because underpriced.” They are characterized by low price-to-earning, low price-to-book ratios, and low price-to-sales. They have slower growth rates are often out-of-favor, overlooked, challenged and boring.
Since 2008 investors have heavily favored growth. Why? Over the last 13 years the US Federal Reserve and Congress have kept in place emergency measures in the form of:
- increasing money supply (see chart below);
- suppressed interest rates;
- corporate bailouts; and
- fiscal largesse in the form of huge spending packages and direct payment to individuals.
In 2021 alone, Congress will have spent $6.8 trillion through direct payments, new programs and myriad spending bills. Exploding returns and net worths have induced a sort of recklessness among investors that we haven’t seen in, well, forever.
Growth investing, up until now, has worked well. The surplus of cash, easy credit terms and low interest rates has fostered a speculative mentality. The importance of a company’s asset quality and profitability has given way to the allure of pie-in-the-sky dreams and cool new technologies. Financial analysis has not mattered in such an environment because very few are concerned with the price-value relationship of new investments. It is assumed that past (blow-out) returns will repeat themselves, and to miss out on big returns is a cardinal sin. Evaluating risk/return has taken a back seat.
From a professional investor’s standpoint, it is much easier to go along with the crowd and pile into barely profitable companies as the markets rise, rather than to maintain discipline and explain why returns aren’t keeping pace. Ironically lagging returns in a highly speculative market reflects the cost of avoiding potentially massive losses. The tech bubble of 1999 – 2000 taught us this lesson.
In the investment business you often get punished for doing right by your clients. Legendary value investor Gary Brinson was forced into retirement from his top position at UBS’ Global Asset Management because he maintained investment discipline during a bubble. He avoided the tech and dotcom speculations of the late 1990s when everyone else was piling into those very stocks that tumbled 70% - 80% right after his departure.
Value investing is harder than growth investing because real value exists where other investors are skeptical
. Value investing requires deep digging into details to form a solid financial perspective. Human nature wants to avoid such challenges and hard work. We want it to be easy. But in investing there is no “easy”. As Jim Grant says, “you can have bad news and cheap, or you can have good news and expensive, but you can’t have good news and cheap.”
In my 30 years of investing, I have found that in all types of markets it is much easier to make money in situations that are not as bad as what widespread pessimists believe, than it is to make money in situations that are better than what the widespread optimists believe. And the kicker is that, generally, to invest in situations surrounded by widespread skepticism carries less downside risk than situations where prices have been run up by widespread ebullience. Since pessimism is reflected in a value stock’s price, marginal sellers are mostly gone…so downside can be limited. But it’s much harder to invest this way.
People feel comfort by going with the crowd -- comfort by doing what everyone else is doing. Investors like being part of a consensus. Even if the crowd or the consensus is making a collective mistake or is flat out wrong. It is easily forgivable to make the same mistake that everyone else is. This is especially true of professional or institutional investors because their career reputation is driven by ‘performance’ -- not by the risks assumed to earn their performance. For professional investors it can be career suicide to go against the crowd and be wrong. This leads to groupthink and herding behavior.
Evolution causes us to be short-term oriented. People are focused on the immediate, i.e., what is happening today. It is a vestige of our survival instincts to perceive threats and opportunities within what is right in front of us. It is much harder to think about risks that may take weeks, months or years to materialize. Because humans are social/tribal beings we seek protection, shelter and acceptance from the crowd. There is a belief that the crowd knows what it is doing and, accordingly, we willingly relinquish decision-making to the herd. We often don’t consider if those people really have our back or know what they are doing. Oftentimes, they don’t, which is why bubbles happen.
Furthermore, confirmation bias, the tendency to only consider evidence that confirms our beliefs and to discount contravening evidence, is a real phenomenon. It is harder to question ourselves and to consider a broader range of possible futures. If an investment or investment strategy is “working”, we believe it will continue to work because confirmation bias reinforces that conclusion.
And beyond that, to invest in a controversial situation requires one to explain themselves. And advisors don’t like to have to explain themselves. They would prefer not to. Crowd-followers don’t have to. While it is certainly an easier, less fraught path for advisors to go along with the crowd, and even may work for a little while, it does not work in the long run. Here is the evidence:
If you look at the bottom panel on the above chart, you will see that since 1926 value stocks have returned 32 times more than growth stocks. Indeed, 95 years is a long time, but that outperformance is staggering. Even if you compound that performance difference over a shorter period it is still significant. Over an 18-year period, you would have made twice as much money in value stocks than growth. On average, value stocks beat growth stocks by 3.8% per annum. How? Because in down months value stocks outperform growth stocks by 1.4% (vs. growth stocks’ outperform value in up months by 0.3%).
What makes it harder and less popular to invest in value (even though it offers better returns with less risk) is that it takes an analytical rigor that growth or momentum investing does not. Growth investing is about buying what is popular and fashionable and exciting. Anyone can do that. Value investing is about understanding the underlying economics of a business, and estimating its future cash flow and risk to derive the stock’s present value. And to also read through the footnotes of the financials to look for hidden risks. Growth investing throws all of that out in favor of guesses about what might be popular in the future.
The reason why vetting stocks by value is far superior is that, properly done, those stocks do not carry the humongous downside risk that growth stocks do when speculative bubbles burst. During periods when markets are inflated by a Fed-sponsored credit expansion, value stocks may not collectively earn the highest returns, but you also won’t incur permanent losses when the expansion ends and broad stock prices turn south. Technology stocks went down 75% in 2 ½ years starting in 2000. Many went to zero.
Why value investing now?
For one, per the chart below, a continued uptick in inflation could easily bring increasing interest rates – an environment where value stocks thrive.
Secondly, stock prices (relative to value) are more stretched now than they were during the 1999 – 2000 tech bubble. The two charts below show that stock prices relative to sales, and stock prices relative to earnings are near previous peaks. Which argues for a continuing cautious approach.
Because today’s prices are at high levels, growth stocks have a tremendous amount of risk going forward, not only from hyper-inflated prices, but unfortunately because the Federal Reserve and Congress now face challenges to their “accommodative” policies. If Congress and the Fed continue their emergency policies of giving away money, printing money, suppressing interest rates and imposing new regulations (that all drive up the cost of doing business and the cost of living), it will compress profit margins. Or they can begin to reduce the stimulus and shrink the wildly optimistic market multiples (as seen in the above high price-to-earnings and price-to-sales ratios). Either way, today has high risk and growth stocks carry a lot of downside.
Why do value stocks make more sense for today’s investor? There has been a very long period of growth outperformance. And markets revert to the mean. Nothing continues forever. During periods where the Federal Reserve and the government have intervened heavily in markets, growth has tended to outperform. While intervention will certainly continue, it is causing inflationary pressure, has unintended consequences, and markets can’t rely on government props forever. Moreover, the Covid emergency has mostly abated so the “need” is declining. And the effectiveness of further interventions will probably begin to decline from today’s extreme levels.
When value outperforms, the move can be quick and dramatic. The chart below shows that growth stocks outperformed value stocks between 1989 and 2000. Growth stocks then gave back that entire 11 years of outperformance in 13 months.
While investing in value stocks is not sexy or crowd-pleasing or good fodder for cocktail party chatter, it is the best way to preserve and grow your net worth. Caution works. Caution can make a ton of money after periods when the rest of the world has lost its collective mind and is chasing heavily promoted Wall Street and CNBC stories without regard to risk (like today). Caution can be expressed by avoiding crowded speculative bets, by paying attention to what you are doing, by buying cheap and understanding what you own. It is critical to estimate how much an investment is likely to be worth, to not overpay and to not invest in future bankruptcies.
The name of the investing game is to earn high compound returns with low risk. That’s it. What is popular with today’s investors is just white noise that should be ignored. Popular investments are usually bought for optics, a fear of missing out and to benefit the career aspirations of professional investors. To invest without regard to economics or prices paid is to expose oneself to high downside unrecoverable risk that will hurt your ability to earn high compound returns.
We try hard to stay away from bad risks and to protect you from permanent losses by not overpaying and avoiding future bankruptcies. And we want to make money with investments that have tremendous long-term upside. We let time work in our favor while other advisors chase speculative investments and play beat the clock in a high stakes game of musical chairs.
We can help you improve your portfolio and assess your risk. We work exclusively with high-net-worth individuals and strive to earn high compound returns while avoiding undue risk and permanent losses. We do this by investing conservatively on your behalf. We do the hard detailed work for you. Please contact us at firstname.lastname@example.org or 303-968-1230 to set up a no-obligation portfolio review and we will give you an objective assessment of how well your portfolio is set up to perform for you.
1 Source: BCA Research