Mark Fairbairn explains value and growth investing styles. What exactly are these investment styles, which is better, and why is it so important today?
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For Episode 4 of the MD Market Watch Podcast, Mark Fairbairn, Assistant Vice President and Portfolio Manager of the Multi-Asset Management team, explains value and growth investing, which is better, and why it’s so important right now.
What are value and growth investing styles?
Mark [0:47] Sure. At the most basic level, so value investing, is, you know, traditionally the concept of just buying assets or stocks at a lower price with the hope that they then re-rate to a higher value or just through having a lower valuation, they just have a higher rate of return over time.
Growth investing is the other opposite, or the other end of the spectrum rather, where you're looking to buy an investment that grows over time. So if you think back to, you know, if you're trying to do better than the market or get a better rate of return, it's really, are you buying assets that you think are undervalued and likely to be worth more in the future as their valuation corrects, or you're trying to buy assets that are just going to outgrow the market over time and be persistent?
That's the short, high level, if you will, and this goes back – there's a long history of it. I think starting back in 1934, Benjamin Graham and David Dodd came out with their book Securities Analysis. That was really the layout of value investing, their most famous and successful student, Warren Buffett is a big proponent – one of the most famous and successful investors. Sort of, you know, really, the concept was to take investing beyond just speculation, you know, either just getting a dividend for your retirement or buying an investment you think would go up. That really set up the tenants of securities analysis. What's this business worth? What are its expected outcomes going forward? And from there, not looking at the company so much, but the rate of return.
Maybe more basically, value investing is perhaps the original form of investing, if you will. So before that, it was people didn't really know what they're doing. So that book came out in the Great Depression, though it was a way to actually look at a company as an investment – figure out what it's worth. Over time, like in the 80s and 90s, what ended up happening is it became institutionalized because we had more you know – the advent of computers, the advent of databases – academics at that point started to be able to do statistical analysis. So, take all those stocks in the universe, rank them based on various valuation metrics. Usually simple ones like book-to-price or earnings-to-price to get a sense of what's an expensive versus a cheap company. And then those studies found over time that the cheap companies tended to outperform the expensive companies fairly consistently and by a fairly significant manner.
That led to, you know, the Fama-French or Eugene Fama and Kenneth French, their study in 1992 that sort of created the high minus low – so high book-to-market versus low book-to-market. So cheap stocks versus expensive stocks as a valuation factor which tended to, over time, add value.
Other ones where like Joseph Lakonishok or Andrei Shleifer and Robert Vishny took a more behavioural component, determined that investors tended to overpay for glamorous growth companies, underpay for out-of-favour companies and that led to expectations to disappoint on the growth companies. Expectations rebound on the out-of-favour companies and that over time led to an outperformance of value. Now your risk premium approach, you're getting paid to take additional risk of investing in out-of-favour companies or just behaviourally, people over appreciate growth and underappreciated value, but they both came to the same conclusion that value, over time, tended to work.
If you think of the growth companies, you know, Amazon, Shopify, Netflix, companies where they're clearly growing very fast. Amazon, I think, has grown at more than 20% in each of the last five years, 30% per year for the past 20 years. That's their top line sales. Tremendous growth. And the company has gone from a book retailer to one of the largest companies in the United States offering web services, selling everything you can.
The flip side of that is bricks and mortar retailers. So if you took a Macy's, Macy's has a deeply discounted valuation because people aren't even sure if the company will survive. It's sort of a shifting of favour – old bricks and mortar, companies like Macy's, online retailing like Amazon – and the differential in valuation tended to be, is stark. Before COVID-19, the correction, Macy's was I think at the end of 2019 five to six times earnings. Whereas Amazon's is like more than 100 times earnings.
The differential in growth is stark. But beyond that, there's a spectrum. So, you'll have within that banks. So, financials is a large mature industry. It has a purpose, it's likely to be around. I mean no industry is immune from disruption, but no matter what, [we're] likely going to need banking services – payments, financing. So, there's a role for banks in the economy, but at the same time it's not going to be a big secular growth demand. Banks will trade not at rock bottom, like a company where you don't know if it's going to be in business, but it's not going to trade at 100 times earnings. Like right now, valuations have come down due to the uncertainty in the market related to the COVID and the economic overhang, but in Canada, the large banks tend to trade around 8 to 10 times earnings.
Which style is better?
Mark [5:24] That is the million-dollar question. So, I mean, historically, if you were to do one thing, it's actually always been value. So, there’s lots of academic research detailing the value premium, the fact that cheaper companies tend to do better, whether it's due to a risk premium as I discussed, or due to behavioural expectations. In general, and this is born out through – you just look at the indices – so the Russell 1000 Growth versus the Russell 1000 Value or internationally the MSCI EAFE Growth versus the MSCI EAFE Value. Over time since the 1970s or 1980s, since those indices started, you end up with a significant outperformance of the value index over the growth index.
So, it cycles through time. Over the short term, value and growth cycle, if you will. Growth companies can be in-favour, specifically if people think that, you know you're going through a period of growth or whatnot, but overall value has been where you wanted to be.
Up until the financial crisis. So, the 2008 financial crisis really was a turning point in the value versus growth behaviour. So up until that point, value not only tended to provide a better return, it did it with a bit less risk. So, you know, and the biggest evidence of this was perhaps the IT bubble back in 2000. So, at that point, you had the market just piling into these companies on hope that they would be the next big thing, and this was the next great industrial revolution. Investors wanted a piece of it, and were paying any price for it and paid nothing for the other companies. And then obviously, that was a bubble. And then those collapsed and you had a recession.
But the value companies, value indices and the companies that made up the value indices, performed much better through that period because they weren't, they weren't part of that euphoria in the tech bubble. So that led to that expectation, and it was, you know, in line with Graham and Dodd’s concept of value investing. So, you know, not trying to get rich quick, trying to get rich slowly, concept of over time just buy businesses at good prices and eventually enough, it'll grow.
Bringing that back to 2008. What you saw there was a financial crisis driven by a housing bubble, not an IT bubble. It was houses, the bubbles in the housing market and that bubble in the housing market was financed through the banking system that led to a collapse, not in Canada, fortunately, but outside of Canada, for the most part, a collapse in the banking system. So, you saw a massive dilution in banks as governments had to bail them out. So that in itself, I mean, I think going into the 2008 crash, value actually underperformed growth by 400 basis points, I think, when you look just like, you know, for the 12 months prior to March 2009. Almost all of it was explained by that difference in the financials. So, for the first time, a localised financial crisis that just did worse than anything because they were imploding, led to the shift and all of a sudden value didn't prove to be defensive. In fact, it did worse than the growth index.
Coming out of that, what you've had is this new normal, if you will, slow growth environment as the world delevers – growth rates, populations slows and whatnot. Just the economy or the world hasn't been growing as fast as it used to. And there's been shifts. So, within that environment, for a lot of the period since the financial crisis earlier on, banks, you know, going through deleveraging and building up their balance sheets, strengthen their business. Although meanwhile, you had these relatively young companies, really in the tech sector, come to dominance.
So, you know, Amazon, a book retailer just continued to grow, continued to reinvest in the business, continued to take over the world of retail and even to some degree, invent the cloud computing service. They didn't invent it, but really brought the – you know, through Amazon Web Services, that built out all this infrastructure to host their own website and realised they had excess capacity they could sell to others.
You've had the rise of Google. So, everything that you search on. At the time, you know, it seemed like a search engine. What you don't realise is more and more shopping, well now it's obvious, but at the time, more and more shopping and just information is gathered – what’s the first thing you do if you want to find something, you Google it. As a result, Google's become one of the biggest advertisers in the world.
Same thing with Facebook, a lot of IT businesses these days are really advertising businesses to some degree, especially in the media space.
You've also had the shift out of, you know, cable TV, watching the news, waiting for commercials. Everything's moving towards online streaming. Phone through, you know, smartphones, Apple devices, Android devices, everything's consumed through your phone, everything is online. The shift from the computer to your mobile devices has really been stark and globally all over the world. So, you've had these big tectonic shifts. It is really I think all of the disruption that people were hyped up for in the 2000s kind of came to life in the 2010s, if you will.
Those big companies, really, or big tech companies and disruptors, really caught their stride and continue to grow and do well in this low growth environment, with low interest rates as the other component of this. So, through this period, you've had very low interest rates globally in response to the financial crisis and low growth rates. So, if your growth is tied to the economy and the economy is not growing that well, and it's perhaps a bit more risky to some degree, it's a somewhat rational to not favour companies tied to that as much.
Conversely, if a company though, regardless of whatever the economy is just facing secular growth winds and growth is hard to come by, more people want that. And you've kind of seen that to some degree where money, as you know, fled out of this old economy, if you will, into these more growthy names within the market. And that has contributed to a large part, this massive outperformance that you've seen from growth versus value since the financial crisis.
And it's not even, leading into the tech bubble, you had a very sharp underperformance of value and then a very sharp recovery and outperformance of value as the bubble collapsed.
This has been, for value investors, a bit of a death by a thousand cuts, if you will. It's just year in, year out, growth just continues to grind higher versus value. But it's come just consistently over time, in contrast to those previous times.
The other factor throughout that period is energy tends to be more predominant in the value indices. And energy is not, starting in about 2006 – $200 prices for oil, peak oil. It's really gone the other direction. Oil prices have come down. It came down first in 2016 or 2014 to 2016 during the rise of shale oil production in the U.S. And then more recently, again with the COVID related shocks, but also a shift to climate change. And those factors are really starting to question, you know, the stranded assets of energy companies. So, people or Investors [are] less likely or less willing to, perhaps look through short-term oil prices and start to wonder, you know, 10, 20 years from now, are we going to be filling our cars with gas? Or are we going to be charging our cars at home? So that's kind of raise some questions around the long-term sustainability of energy companies, which are in the value index. So, kind of got this perfect storm, if you will, from a value versus growth style over the past 10 years.
If you look through, about five companies have explained almost half of the outperformance between the two. So, you know, Facebook, Amazon, Apple, Netflix, Microsoft and a handful of others. Like these companies have really grown to dominance. Microsoft, Amazon – trillion-dollar companies, Apple before it. So, there is an element of concentration within the growth as well.
How does MD Financial Management use each style in our portfolios?
Mark [12:53] So we make use of them both. So actually, I mean, historically, if you went back to the history of MD with the original, you know, MD Growth [Fund], which is ironic, it's called the MD Growth, but it was never really a growth fund, it was just growth as in it would grow over time because the fund pre-dated those definitions of value-growth, which really came out in the 80s. But overall, we tended to have a bit of a value bias. But over the past 10, 12 or so years, we've really shifted to more of a core approach, if you will. Where we blend both value and growth, recognizing that there's a place for both of them in the portfolio.
And this is where I think it starts to come into the concept – so up until this point what we've been talking about is indexes, so just statistically the basket of securities that are growth, this basket of securities that are value – but when you start to peel it back and look at it on an active basis, picking and choosing stocks amongst those, you lead to two different skill sets that are required to not just harvest any premium, but actually add value.
So, when you look at a value manager, what we're really hoping for is that when you're buying value, that it's actual value. So, a company that's going out of business may look cheap, but it's just cheap because it's going out of business. A company with, you know, horrific growth will be cheap, but it should be cheap. So, what we want, and that's the whole concept of that value trap, if you will. You want to make sure that what you're buying is actually discounted and not just cheap. And that's where, you know, active management comes in. And especially probably more so now, where you're in this period of immense disruption, you ought to make sure that, you know, the companies that you're buying at these low, reduced valuations are likely to make it through this period and truly cheap.
The flip side of that is on the growth side. So, the growth side is – the one reason that's sort of held out to why growth prior to 2008, never really worked as a long-term buy and hold strategy was that, markets are competitive, economies are competitive, nothing lasts forever. So, it's perfectly rational to pay up for a company that's growing quickly, but it's very easy to overpay for that growth or have that growth subsequently disappoint. So, you can have a business, growth business doing great. Competition comes into that, slows the growth or they exceed their market. Leads to the growth vectors of that business, slowing significantly, results in a significant re-rating lower of that stock. So when it comes to growth investing, you want to make sure that these companies, that you really understand what is sustainable growth, what's a reasonable amount of growth you can get, and that even just like the value managers, you're paying the right price for that growth. A company may deliver on its growth but may not be a good investment. There's a lot of cases of this, of companies that have just had tremendous operating success over a period of 10 years and had pretty dismal returns over that period just because their valuation came in.
One good example of this is actually Microsoft. So, Microsoft, everybody knows, was the poster child of growth. You know, a strong business, big barriers of entry, like a great business that just always did well, traded at a premium valuation. But around the early to mid-2000s, started to get this concern over Microsoft – was it stagnating? Is it too big? Is it not growing enough? And then later on, you started to get the mobile. Microsoft makes operating systems and Microsoft Office and it's all geared in the desktop. In 10 years, nobody will have a desktop computer, they'll just do everything on their phone. And what you actually saw was Microsoft actually, their valuation – so the business operating metrics on the headline number, top-line growth or earnings, it can still seem like a reasonably good company from those fundamental metrics – but it really de-rated down to a value stock valuation and it was actually in the value index at one point.
So, it's just an example of where what was a star may not be a star. So, I mean, I think at the time people would look at the difference between Apple overtaking it as the largest company and the sign that, you know, Microsoft was assigned to the grind down with the PC computer. But ultimately what happened is you had new management come in at Microsoft and really re-focused the business and turned around the growth. So, you know, focusing more on cloud, focusing more on subscription services, like through the Office 365 that we use at work. What you have actually seen is Microsoft has actually recovered, to now have once again overtaken Apple as the largest company. And now you start to see the other component where Apple – how many iPhones do people need? Everybody has an iPhone. Android phones offer most of the functionality and many of the lower prices – you have competition in China, which is a large portion of their sales. So, the sentiment around these growth stocks really ebbs and flows. So, you need to have a fundamental understanding of the business and what you're paying for it to really be successful. Just like in the value stocks, you need to understand that what you're buying is actually value and not just, you know, value traps or paying up for cheap.
When we bring the two together, what we're hoping for is, we know that value and growth will ebb and flow. I think historically values tended to, on balance, win, if you will, to just do one thing. But you can get a lot of value add in the growth strategies as well. And I'd say this approach has really helped client portfolios recently, recently being the last 10 years, because if we had maintained that strong value bias, focusing only on value, we would have missed out on a lot of the strong performance of growth.
But by blending the two, you know, if our value managers could do better than value indices and our growth managers can do better than growth indices, you put the two together. We can hopefully diversify away the cyclicality between growth and value and capture a more durable, diversified portfolio that performs through time that meets our client’s goals of meeting their retirement or other financial objectives.
In the last podcast, Ed Golding talked about taking some time to reflect on the relationship between value and growth investing. In the episode before that, Craig Maddock mentioned the historic patterns of the two investing styles. Why is this something that we're watching so closely?
Mark [18:44] So if you think back to the 2000's, I mean, the poster child of the IT boom was Pets.com – like just a dumb business. That's not the case right now. The challenge that you face now is this big period of disruption. And the companies, that are the growth companies, are good companies – like their strong balance sheets, they have massive amounts of cash, they have a reason to be a business, a reason to be in business for a while. Whereas a lot of these other companies have to figure out how to make this challenge to this more digital world, if you will, and find their place.
And they'll do it. So, I don't think it's just everybody's going to roll over and let Amazon and the like take all their business. They're going to figure out a way to make themselves competitive, but they have to make that transition. And then within that, you do have larger segments of the value universe that perhaps have a bit more challenged outlook going over it. So, the challenge we're having is just really understanding, what’s the appropriate role between the two and the balance, and is there a reason to favour one more versus the other.
The other big change that I haven't really touched on is that risk component. The other thing that we've noted is, if you think of quality companies with strong balance sheets, lack of leverage, strong growth. These are companies that are a bit more durable. So outside of the valuation, their businesses are arguably a bit safer. Whereas the value index, due to this change over the recent years, has really become a bit more cyclical, more economically sensitive – so you know, automakers, materials companies, industrial companies that feed into supply chains, logistics companies. So you get like sort of these companies that have a lot more economic sensitivity and this was really laid bare, now this is a one off environment, but the recent shocks related to COVID, there's a huge divergence between value and growth companies because the company that are more sensitive to economic growth – the cheaper companies – where that economic growth is really uncertain. So, when are you going to go back to the store? When are you going to go to a movie theatre? When are you going to take a trip on an airline? Stay in a hotel? Those are questions that don't have clear answers.
But what you do know is you're still buying stuff on Amazon, you're still using your phone, you're still Googling stuff, you're still on Facebook, you're still watching Netflix. Like these businesses still have a purpose here and right now. And they have, in many cases, the cash and the financial willpower to withstand any weakness.
Within that, you saw, through the trough, that we've seen thus far in March, strong outperformance with those growth names. You've also seen them lead the rebound, because now people are looking at, now they've sold off, I'm going to buy back in. So, you've had a, really just from growth versus value, a horrible 12-month period. A massive underperformance in the March sell off due to that sort of economic sensitivity and concerns. And they participate in the rebound either to the same degree. So, the differences between the two are quite stark, the difference between the value in the growth indices, is literally like 20% difference.
So, it's really separated out. So, part of that deeper dive to look into it is to really get a sense of in 10 years say, what's the world going to look like? And which styles are better focused to capitalize on that?
The flip side of that, is other risks, is just more the political risk. So, I mean, you have these other companies that are, to some degree, becoming what looks more and more like a monopoly, if you will, in terms of their dominant position. So, you are also exposed at the same time [to] the political risks associated with does Amazon get broken up? Does Google face regulatory constraints? So those are the other uncertainties that would be risks on those.
The differences in evaluation as well. So, although the companies today are much better, stronger than they were in 2000's, the difference in valuations, so if you just divided through the valuation of the value indices, through the growth indices, growth obviously always trades at a premium to value. But the value of that premium is stark. It's as high as it's been in years, in part driven by the recent 12 months or so of just a massive widening. And a lot of that is not due entirely to the growth index being incredibly expensive, but just the fact that the value indices have become very cheap. So, it's more a case of the value stocks being as low as they've historically been while the growth indices are more expensive than they've been recently. But it's not off the charts valuations you saw in the tech bubble.
So those are the answers we have to balance ourselves on. Sort of, you know the, perhaps political and valuation risk in these great, high-quality growth franchises versus perhaps the existential threat in the businesses present in value indices.
Has this trend impacted our strategy or perspective in any way?
Mark [23:15] No, not currently. So, I think generally our funds are, for the most part, core. There is a blending of the two. I say all of our strategies tend to look at both growth and value. It's not a bit of a binary because there's a whole spectrum in the middle of companies that are just higher quality, not super growth, not super cheap. So, we try a diversify approach. So, we haven't had any major shifts in those. But we have seen just that stark underperformance of some our value funds, which from a client looking at a portfolio really stand out. So, I would just take a look at what actions we could do to perhaps ensure that those are best positioned going forward. But I think from a client perspective, it's important to look at it from your total portfolio – so don't just only look at the terrible performance of your value fund, contrast it against also the strong performance of your growth funds.
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