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Value Stocks – The “Deacon Blues” of Investing

Timothy GroveJuly 5, 2019

Investments

In Steely Dan’s 1977 hit song, “Deacon Blues,” the protagonist (an unpopular “loser” and a “nobody”) laments the fact that, unlike the “winners in the world,” he doesn’t have a flashy nickname.  So, wanting “a name when he loses,” he coins one for himself – “Deacon Blues.”

The winners in the stock world, the “darlings of Wall Street,” often get flashy nicknames too:  the “Tronics” of the early 1960s, the “Nifty Fifty” of the early 1970s and the “Dot Coms” of the late 1990s.  One thing all these stocks have in common is they all were/are a subset of “growth” style stocks, as opposed to the unloved (and nickname-less) “value” stocks.  Another condition they have in common is their crash back down to earth in spectacular fashion.  Now, more than two decades later, we have a new group of “growth” stocks sporting a flashy nickname – the “FAANG” stocks—Facebook, Amazon, Apple, Netflix, and Google/Alphabet.

When an investor buys stock in a company, he or she is paying for a share of ownership in that company.  This entails a share of the company’s earnings, sales, cash flow and assets.  The amount investors are willing to pay for a dollar of these items is measured by dividing the company’s stock price by each of these components:  price/earnings, price/sales, price/cash flow, price/earnings growth, and price/book value.  In financial lingo, these figures are what’s known as “valuations” or “multiples”, with price/earnings, or the P/E ratio, being the one most commonly used. In the case of “growth” stocks, investors are willing to pay more for a dollar of the company’s earnings, assets, etc., as they believe the stock price will go still higher.  In other words, growth stocks are “expensive.”

Value-style stocks, on the other hand, are those that are less costly; investors pay less for a dollar of their earnings, assets, etc. Thus, they have lower “valuations” or “multiples.”  While poorly performing companies or those with a dismal outlook may deserve to decline in price (and will likely stay low or become even less expensive, value-style investors buy stocks that are unjustifiably bargains, because they are simply not in vogue or are overlooked, with the hope that the market at large will come to its collective senses, recognize their true value, and drive the stock price up.

When certain growth-style stocks go one step further and become fads (often acquiring a flashy nickname in the process), the valuations can be pushed to absurd heights, which are not justified by any rational analysis, and a “bubble” ensues.  The proponents of these stocks will invariably respond by saying, “it’s different this time, the old rules don’t apply.”  Famous last words if ever there were any.  You may recall during the “dot com” bubble, there were many companies that did not have earnings at all, resulting in an undefined P/E ratio, because the denominator was zero. Remember what ultimately happened to these firms.

In the 10 years since the end of the financial crisis, growth stocks have outperformed value stocks by substantial margins.  For the trailing three-, five-, and 10-year periods ending June 30, 2019, the Russell 1000 Growth Index has outperformed the Russell 1000 Value Index on an annualized basis by 7.73%, 5.94%, and 3.04% respectively.  There are those who are questioning whether one should invest in value stocks at all.

Legend has it that just before the Crash of 1929, which precipitated the Great Depression, Joseph Kennedy, the patriarch of the Kennedy family, stopped to get his shoes shined, and was shocked when the shoeshine boy proceeded to give him unsolicited stock tips.  At that point, Kennedy realized the stock mania had reached its peak, and it was time to sell stocks.  Yet, I would submit, when people proclaim that value investing is dead, it just might be time to buy value stocks.  After all, the voices announcing the death of value-style investing were, if anything, far louder and more numerous during the dot-com frenzy of the late 1990s.

To paraphrase Mark Twain, reports of the death of value investing may, once again, be greatly exaggerated.   After the dot-com bubble burst (as bubbles tend to do) in early 2000, value stocks outperformed growth for seven of the eight years in the 2000-2007 period.  Prior to that, in the 1994-1999 period, growth was the winner.  So, if history is any indication, we may well be about to begin a period of value out-performance after a decade of growth dominance.  However, since no one can predict exactly when such a rotation will occur, we at HFA believe it is best to maintain a balanced allocation to both growth and value stocks, trimming the winner and adding to the laggard.  This strategy will necessarily employ a proven investment maxim:  sell high, buy low.

Too much of the performance of the growth category being provided by too few stocks is another potential danger with growth stocks that have become a fad, particularly in the current market.   The Russell 1000 indexes are weighted by market capitalization, or the total value of a company’s stock.  Thus, when a company’s stock is performing well, it becomes a larger percentage of the index.  It is worth noting-and rather alarming-that the FAANG stocks now comprise 21.5%, over a fifth, of the Russell 1000 Growth index.  Furthermore, because of their outsized share of the index, these five stocks (out of about 500 in the index*) alone, using their current weightings in the index, are responsible for 6.16% and 5.45% of the margins by which the Russell 1000 Growth beat the Russell 1000 Value for the trailing 3- and 5-year periods ended June 30 (7.73% and 5.94%, respectively**).  Put another way, without the FAANG stocks, the Russell 1000 Growth would have beaten the Russell 1000 Value by only 1.57% and 0.49% for those periods.  Again, this is using the current weightings of the FAANG stocks in the Russell 1000 Growth index.

Comparable to Joseph Kennedy knowing it was time to pare exposure to the stock market when shoeshine boys were giving stock tips, perhaps when a group of stocks gets a flashy nickname, such as “FAANG,” it is time to steer clear of them. Instead, consider the overlooked, the unpopular, the unsung, and the unloved.  Call me “Deacon Blues”!

Sources:

seekingalpha.com
finance.yahoo.com
investors.com
stockmarketschool.com
iris.xyz
businessinsider.com
forbes.com
morningstar.com
azlyrics.com

 

* The Russell 1000 Growth Index and Russell 1000 Value Index are each about half of the Russell 1000 Index, with the stocks categorized as “Growth” or “Value” by their valuation metrics.

** Facebook did not go public until May 2012, so it is not possible to obtain trailing 10-year performance figures for the current “FAANG” stocks.