It's the economy, stupid!
Tuesday's column covered value stocks' long dry spell. After reliably and consistently beating growth companies for decades, lower-priced stocks have lost their edge. Since the mid-1990s, value stocks have roughly matched growth stocks' returns, and during the trailing 10-year period they have lagged. So much for the notion of a "value premium."
In his most recent quarterly letter, Jeremy Grantham, co-founder of the money-management firm GMO, discusses why value investing has struggled. The letter is unusual in that Grantham is himself a value investor, and his organization's funds are suffering net redemptions. Fund executives who find themselves on the wrong side of the financial markets tend to defend their investment approach, not question it.
Fat and Happy
Instead, Grantham grants that this time might indeed be different. In particular, corporate profits have transformed.
Grantham provides the return-on-sales figures for the S&P 500, dating back to 1970. For the first half of the period, the ROS hovers between 4% and 6%. It's artificial to draw a line at 5%, which Grantham does, as if that number represents the sequence's natural midpoint. However, such an exercise does capture the previous spirit of the ROS' behavior.
Then all heck broke loose. The ROS burst through its 25-year band in 1996 (while Alan Greenspan mused about "irrational exuberance"), set another record in 2000, beat that mark again in 2007, and surpassed it once more in 2014. In the period's second half, the past served as no guide whatsoever for the future. Grantham draws another line, illustrating the new equilibrium, but this action is even more artificial than his first. Who can tell where the ROS is headed?
Interest rates, of course, have also confounded expectations by breaking through their historic bands. In the case of interest rates, the barriers were floors rather than ceilings. But the pattern was the same as with corporate profitability. Rates would set new records, observers would whisper worries about their inevitable retreat, and then … interest rates would drop further. The bad news never came.
Given that corporate profits exceeded all predictions, and interest rates dropped below what anybody anticipated, it's no surprise that stock price/earnings ratios moved higher. How could they not? Corporate values are determined by the cash that companies generate (which is directly related to profitability, assuming no hanky-panky with the accounting) and by the interest rates that are used to discount their future receipts. Both measures improved greatly. Stocks had no choice but to rise.
Value investors are creatures of habit. Whereas growth investors cherish the improbable, envisioning companies that achieve what their predecessors could not accomplish, value investors expect what previously occurred to happen again. Grantham's lines are symbolic, but they represent the bedrock faith of a value investor: That which excels (or stumbles) will inevitably head back from whence it came.