The fund management industry spends an inordinate amount of time thinking about factor-based investing, as choosing the correct factor to be long of makes a massive difference in performance versus a global equity benchmark, as seen by the fact that a portfolio of quality growth assets has easily outperformed the MSCI global equities index over the last 13 years. The biggest factor debate is probably around value vs growth and many argue that value is due a return to favour after 13 years of underperformance as seen in this graph below. As a result, value as a strategy is as unloved today, as it was during the Tech bubble in 2000.
Back to the time of the TMT bubble: the stark valuation gap between ‘growth’ and ‘value’ stocks
MSCI Europe – ‘growth’ price performance relative to ‘value’
Source: JP Morgan
As an accountant by training, I have always found myself more aligned with value investing, à la Graham and Dodd, Warren Buffet and Margin of safety and Moats, but after reading “Graham or Growth“ authored by James Anderson, a partner of Baillie Gifford, I am inclined to think I might need to rethink.
He argues in his 50 page document that growth investing might be here to stay (or at least for the next couple of years) and that our traditional ways of valuing companies might need to be relooked at. Value investors love to rely on mean reversion to argue that shares are cheap but Anderson is of the view that this concept is outdated and that this no longer works in a knowledge based world.
If one looks at history, it is during periods of relative calm that Berkshire Hathaway value investing reigns supreme and where history keeps repeating that mean reversion works. But in times of great change and disruption, as we are currently experiencing, it will be difficult for value to do well. If one believes we are entering a period of great change and creative disruption, then growth investing will have a far better opportunity to generate returns. One has to think only of Amazon and Netflix, which have brought great change and reinvented the playing field for the incumbents – mean reversion would not have worked for either a Sears or Blockbuster.
Disciples of value investing also believe that to double earnings over a 10 year period, a typical definition of a growth stock, was hard to come by – especially if the company was large. Based on mean reversion, earnings would fall over time, hence companies would de-rate. But Graham would have been wrong about Microsoft, which has grown earnings by 24% CAGR since 1986 when it listed 33 years ago. Microsoft is just one example and when it comes to the technology growth winners, it is certainly not the exception.
Citibank Professor, Brian Arthur, neatly sums up that mean reversion is not necessarily the correct way to think about knowledge based companies: “So we can usefully think of two economic regimes or worlds: a bulk production world yielding products that essentially are congealed resources with a little knowledge and operating according to Marshall’s principles of diminishing returns and a knowledge based part of the economy yielding products that essentially are congealed knowledge with a little resources and operating under increasing returns“.
This move towards a knowledge based economy not only effects the mean reversion argument of value investing, but also impacts Tobin’s Q ratio, in which companies without physical assets seem incredibly expensive, but those with physical assets might be a value trap – one only has to think of retail space in a world moving towards e-commerce.
Another big picture theme that the world is currently encountering is the fourth industrial revolution and with it, the way we invest will change, just as much as the environment we are living in is changing.
For those ‘dyed in the wool’ value investors, growth investing will never have appeal. I am increasingly coming around to the conclusion that in a world of great change, maybe as investors we need to change the way we “value“ companies. If nothing else, mean reversion and Price-to-Book ratios are something we need to think very carefully about as when it comes to margin of safety, this can very quickly be disrupted. Not only that, but big can be beautiful, thanks to the network effect of the giants such as Amazon, Microsoft and Facebook, to name but a few.
If you don’t believe me, let me leave you with this story from American investor Charlie Munger who had the following to say about “groupie” fund managers that follow Berkshire principles: “They are like a bunch of cod fisherman after all the cod’s been overfished. They don’t catch a lot of cod, but they keep fishing in the same waters. That’s what happened to all those value investors. Maybe they should move to where the fish are“.
Or perhaps it is even simpler than that, has the style of value investing stopped mean reverting?
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