The Investment Management team spent a significant amount of the fourth quarter discussing asset allocation and optimal positioning for 2020. I found our most recent growth and value conversation to be one of the most intriguing and thought provoking, especially as we enter a new year. I hope you find the following takeaways as interesting as I did!
When meeting with portfolio managers over the past year, we found a few noticeable themes. For starters, growth investors are looking to take some money off the table in positions that worked well and were casting a wide net to deploy capital. Meanwhile, value investors were split—with some seeing similarities from 1999 in the landscape of today’s market, while others struggled to identify the appropriate combination of fundamentals and valuations. Let’s further examine the characteristics that led to each group’s conclusions.
In 1999, I was part of a team that managed small- and mid-cap value portfolios. My portion of the investment universe, the Russell 2000 Value Index, was down slightly and underperforming growth by more than 44 percent. The disparity between large-cap value and growth was more than 25 percent. The market was often referred to as a “one-decision market,” as the Nasdaq Composite rose more than 85 percent in 1999, and the technology sector had a 33 percent weight in the S&P 500. Ironically, a number of companies that drove this performance would cease to exist a few years later, including Webvan, eToys.com, and, probably the most recognizable, Pets.com and its much-loved sock puppet. Internet-related stocks were trading on valuation metrics often referred to as price-to-concept, with all other areas of the market being left behind.
Having invested through that environment and learning from those experiences, I can say that today’s opportunity set seems less attractive than it did back then. Attractive valuations and businesses able to generate steady free cash flows yielded the perfect combination for value investors. But the key was enduring long enough to benefit. Those who held steady were rewarded in 2000 and 2001, when small-cap value outperformed growth by more than 45 percent and 34 percent, respectively. Over those years, asset allocation decisions to overweight growth or value were paramount to achieving investment objectives.
Can we expect the same type of value outperformance going forward? In 9 of the past 11 years since the great financial crisis, large-cap value stocks have produced positive returns. Not to mention the double-digit returns in 8 of those years, including 2019 when large-cap value stocks rose 26 percent. Of course, growth rose more than 36 percent, adding to the performance disparity since 2008. But value stocks are up more than 400 percent since the March 2009 low. This is a far cry from flat to down 20 years ago. The prudent outlook would be for a less robust outperformance cycle for value going forward than experienced in the early 2000s.
So, where does this leave us as investors? Pure growth companies with good business models, such as Facebook, Amazon, Netflix, and Alphabet, have been strong performers over multiple years, as reflected by their current valuations. Meanwhile, rate-sensitive value stocks, like utilities, REITs, and some consumer staples, have been bid up as investors look for ways to generate income. And traditional value stocks, like retailers and heavy cyclicals, have seen disruptions to their business models that make long-term fundamentals challenging. Warren Buffett, among others, has opined that book value—a traditional tool for value investors when analyzing these types of companies—has lost its relevance.
But there is a wide middle to the market that can potentially be fertile hunting ground for investors of all stripes. Value can be found in areas of the market that haven’t traditionally been thought of as value sectors. Here, health care and technology come to mind. Growth investors can find long-term growth opportunities in cyclical, secular growers. These companies can have dominant market share positions that allow them to grow through economic cycles, with a kicker of a cyclical upturn if timed correctly. Aggregate companies and some types of packaging companies fit this description.
Over the past year, we have had a value manager and a growth manager both own Microsoft. And their explanation for doing so made sense for each of them. Growth investors focus on the opportunity resulting from the transition to the “cloud,” and value investors focus on cash flow generation. Previously, we have seen this approach with Apple and Schlumberger, among others. Beauty is in the eye of the beholder, as is value or growth!
Stay diversified. Market timing is not easy. When an asset class will outperform will never be 100 percent clear, except in hindsight. Until the opportunity set becomes clearer, managing risk is particularly important. Value and growth decisions become less important than finding managers that are cognizant of the downside while trying to hit singles and doubles. This combination should provide a solid return profile and risk management benefits.
Our Investment Management team has a slight preference to value at this point in the market cycle. But we are also diversified in our approach and have almost as much allocated to growth managers. We believe singles and doubles, while avoiding large drawdowns, allow for solid long-term performance. This balance is what we strive for every day while managing Commonwealth’s Preferred Portfolio Services® Select model suites.