Value Investing is Stuck in the Past
Value investing has underperformed growth for the last decade, is that likely to continue?
First some basics. There’s no exact definition for growth or value investing, and to some degree, all investing is value investing, but for the purposes of this article:
Growth Investing - Investing in companies with strong potential for future growth. These companies often reinvest earnings into expansion, acquisitions, or research and development. They generally have high price-to-earnings ratios, high earnings growth rates, and no dividends. Often young companies and start-ups.
Value Investing - Value investors look for undervalued stocks, or stocks trading for less than what the investor believes they’re worth. Lower price-to-earnings ratios, stable dividends, and potentially slower growth. These companies are often established players in their industries.
After reading an excellent article byabout the existential challenges facing value investing, I thought it’d be interesting to explore just why value investing has performed so poorly over the last 15 years and why I don’t think it’ll make a comeback anytime soon.
That value investing has underperformed, and by a considerable margin, is undeniable. But why?
Why has value investing underperformed?
You might think it’s purely because the returns in the market have been driven purely by the big tech companies. However, as the article mentioned above notes, even if you use the S&P Midcap 400 index, it still outperforms almost all the famous value investors.
I think there are a few different answers as to why, but I’ll go through some of what might be are the main ones below.
Low Interest Rates: An obvious but important one. The past decade has seen, what have historically been, incredibly low-interest rates. As this brilliant article on Visual Capitalist points out, interest rates were around their lowest level in the past 220 years from 2010 - 2020. Lower rates lessen the cost of borrowing and help companies that need debt to fuel their growth. Growth companies, often not profitable in their early stages, could finance expansion more cheaply in the low-interest rate environment from 2010 - 2020.
Technological Advances: Technology, especially AI, now means that even a start-up has access to technology like ChatGPT that can do a lot of the coding and copywriting that a company would normally have to pay someone to do. Start-ups can therefore put more money into product development and other areas of the business to grow faster and gain market share.
Shift in Consumer Behaviour: Gen Z and millennials expect tech to be baked into everything. From cars to fridges, technology now pervades our entire life and the companies which adopt it fastest and create a great user experience are being rewarded for it. A great example of this is the rise of neo-banks like Revolut and SoFi. When they began, they might not have the capital of a more established bank to invest in product development, but they have been successful by making the user experience much better than a traditional banking app.
Other reasons which have undoubtedly helped include:
Rise of passive investing, especially in ETFs and indices: Makes it harder for value investors to find mispriced companies when people are buying everything in an index and sometimes holding it for decades.
Lack of a recession: 2010 - 2020 was the first time the US economy had gone an entire decade without entering a recession. And the recession during Covid, although deep, only lasted 2 months. Since they’re often not profitable and rely on consumer spending to fuel their growth, growth stocks tend to be hit harder by a recession than more established companies.
The rise of globalization: Globalization makes rapid expansion and scaling overseas much easier and opens up new markets for faster and broader dissemination of technology. It helps value companies too, but in my opinion, tech companies generally benefit more from this feature of the modern world.
Of course, there are undoubtedly dozens of smaller reasons that synergize together and have been behind the success of growth investors as well but I think the main ones are covered above.
Growth investors have outperformed because tech companies have outperformed - they can just scale quicker.
When a brick and mortar store moves into a new location it has to hire staff, find land to build on or an existing building to move into and then import the products and set up the shop. Not to mention passing through all the regulations that moving into a new area might entail. Even then, they might only be able to sell to people within a 50 mile radius of the store.
An ecommerce company on the other hand, can sell to people hundreds of miles away from its distribution centres. Its website, once built, can be accessed by thousands of people simultaneously who can all order different products.
It’s more convenient for the customer and, since the company will likely be aiming to sell thousands of products, it can afford to have smaller margins on each product and undercut the brick and mortar store.
Their overhead costs don’t change much regardless of how many people use them. If a brick and mortar store has 500 regular customers and wants to expand it to 5,000, it needs to go through all the problems that opening multiple new stores entails. An ecommerce company only needs to buy more product and hire more drivers to deliver them, a much simpler process.
This cost difference for producing and selling additional goods is known as marginal cost. Some tech companies barely have any marginal cost at all. Netflix for example pays virtually the same amount to produce and show a program regardless of how many people actually end up watching it.
Understanding that tech businesses have a lower marginal cost of producing a good is key to understanding why they’ve performed so well in the recent past.
Will it continue and what does it mean for investors?
To me at least, it seems very likely that the outperformance of growth companies will continue. With the possible exception of some aspects of globalization, all the factors mentioned above are either here to stay or accelerating.
Interest rates are widely expected to fall throughout 2024, along with inflation. Some investors are even predicting that deflation could become a larger problem further into the decade, as more people are replaced with technology and the aging population in the West spends less.
The latter point isn’t necessarily a given. There’s some controversy over how an aging population affects the inflationary environment, but in the most extreme case we’ve seen until now, Japan, it’s clearly been deflationary. Opportunities will still present themselves to value investors and, as we saw in 2022, there will surely still be great times to buy tech companies at discounted prices.
The rate of innovation also seems to be increasing. There was a mind blowing amount of AI breakthroughs and new products released in 2023, coming just months after arguably the most society-impacting breakthrough of the last 15 years, ChatGPT. If the rate of innovation continues to rise, it’s a safe bet that the companies building the new tech will become more valuable.
“Volatility is the price of admission. The prizes inside are superior long-term returns. You have to pay the price to get the returns.” - Morgan Housel, best-selling author.
Assuming you can weather the higher volatility that comes with owning them, if the next decade is anything like the former, it promises to be a good one for tech investors.
There are no certainties of course and how much you want to allocate to growth vs value is up to you. But if you believe that growth stocks will continue to outperform and if you can stomach the volatility, investing in them is the best thing you can do.