The Case for Value Stocks
The goal of our investment portfolios is to accumulate and maintain the financial resources needed to meet your objectives. We seek to accomplish this by fully unleashing the compounding power of your investments. Compounding is cumulative. It’s about moving forward – returns steadily building on returns – trying to avoid a volatile pattern of big gains followed by steep losses.
Effective and sustainable compounding requires consistent high-quality absolute returns. An absolute return is the actual return earned on capital placed at risk. While not every return will be positive, large losses can reverse years of gains and keep you from reaching your goals. That’s why we always seek to place the odds in your favor and why we’re equally concerned about gains and the potential for large losses.
Our goal is to swing at the right pitch. This can test one’s patience, but we’ve found that being disciplined yields great rewards. Reduced to its basic elements, an investment in equities is about owning future earnings (profits) at market prices that will yield an attractive long-term return. It’s been well documented how a few large growth stocks, like Apple, Microsoft and Google, have been responsible for much of the S&P 500’s performance. Investors have piled into these names, taking valuations to highly expensive levels. In the past, valuations at these levels have often led to large losses and a range of 10-year returns that fall below 0%/year. Neither scenario helps compound returns.
What the S&P 500’s uneven performance has masked is a stark difference between growth and value stocks. The opportunity to own value stocks is one we’ve been following for some time. Chart 1 shows the year-to-date difference in returns and Chart 2 shows their prices relative to expected earnings. While large-company growth stocks have outperformed, grabbing the headlines, large-company value stocks such as Berkshire Hathaway and JP Morgan Chase have quietly become increasingly attractive as sustainable long-term investments. As a group, these are well-run companies that have continued to post profits through difficult times and have maintained a 2.5% dividend.
Value stocks tend to be more economically sensitive, and we’ve resisted purchasing these shares waiting for more clarity. While there’s never a perfect conviction in investing, recent positive news about the development of a vaccine for COVID-19 and the prospect for a less-contentious path to additional fiscal stimulus has led us to conclude that now is the time to begin accumulating these shares. Accordingly, we’ve begun selling defensive assets and taking a position in a low-cost ETF investing in large-cap value stocks for equity-focused and balanced portfolios. We may purchase additional shares as events unfold.
Prospect for Relative Outperformance
While we’ve purchased these shares based on their absolute return potential over our traditional time horizon, value stocks may also be poised for strong relative returns. This would be a bonus. Generally, leadership between value and growth rotates back and forth. Over the last 10 years, growth has outperformed by record margins, which is one of the reasons why it’s represented a large portion of our stock positions for much of this period.
There have only been two other periods when growth has outperformed by similarly wide margins. In both instances, a large price correction eventually occurred, leadership rotated, and value outperformed by roughly 10%/yr. and 8%/yr. for the next 10 years (see Chart 3 above). Regardless of whether we’re now at an inflection point or if history repeats, we believe large-cap value represents an excellent and now timely opportunity for absolute gain with a lower probability of loss. Thus, we’re positioning our portfolios accordingly.
We continue to analyze a number of opportunities in light of recent developments. Small-cap value stocks, emerging markets and emerging markets value stocks, high-yield bonds, and alternatives are currently on our radar. Some of these may make it into our portfolios; others will require more patience. We will keep you posted.
Thank you for the privilege of allowing us to guide your portfolio through these challenging times. As always, we welcome your questions and observations.