This column was originally published on Nov. 10, 2015.
The Rich Get Richer Growth stocks have whupped value stocks over the past five years. Through Friday, the Morningstar Large Growth Stock Index had gained 15.46%, with Large Value at 10.96%. That annual gap of 4.5 percentage points leads to a big cumulative difference--a 105% profit for Large Growth, as opposed to 68% for Large Value.
"Smart beta" marketers claim that value stocks are for the bright bulbs, with growth companies appealing only to dummies. So, why are the beetle brows ahead?
Classic investment theory cannot answer the question. The capital asset pricing model, or CAPM, theorizes that, because growth companies have higher betas than value stocks, they will lead during a bull market. In practice, this is only slightly correct. Growth companies do tend to outperform when stock prices rise (and drop further when prices decline), but by a much smaller margin than CAPM suggests. The effect is too weak to explain most of those 4.5 percentage points.
The results for small- and mid-cap stocks demonstrate CAPM’s lack of explanatory power. In each of those areas, growth stocks also have higher betas than value stocks, as with large companies. But small- and mid-cap growth companies did not trounce their value counterparts in the rally. Small growth beat small value by a modest 117 basis points per year, while mid-value enjoyed a slightly stronger victory over mid-growth. Overall, the two styles were a wash.
Thus, something different happened with large-growth companies--something that is not addressed by MBA finance classes that teach CAPM. That something was income inequality.
Dumb and Dumber Income inequality is as familiar a subject as it is misunderstood. Everybody has heard about the 1% versus the 99% via political discussions. Democrats decry income inequality as coming from Republican policies. The Republicans have responded either through ostrichlike denials or by countering that, actually, it is President Obama's fault.
Pish, posh, and more pish. Political arguments are like legal arguments--they are made not for the purpose of reaching the truth (which they do occasionally stumble across, but only clumsily and accidentally, as with a blindfolded man seeking a doorknob) but instead so as to win allegiance. Paying them heed does damage to the gray matter. It's no way to invest, either.
What really happened with growth stocks, and with income inequality, was explained this past Thursday by The Wall Street Journal's Greg Ip, in a terrific article titled "Inequality--a Company Thing." (No link because of the Journal's paywall, but you can leap that wall by connecting to the article through a search engine.)
The rich companies got richer.
That is, the driver of income inequality has been neither greedy company executives, per the Democrats’ narrative, nor President Obama’s failings, per the Republican's narrative. (Never mind the ostrich narrative that income inequality has not risen; that bird won’t fly.) It has instead been the inexorable, unmanageable force of corporate profits. The strongest companies have become ever-stronger, which has had the twin effects of boosting their stock prices and of raising their employees’ wages. This broad economic trend has driven the investment success of large-growth stocks. It also has led to the observed income inequality.
Gold Mines First, investments.
Ip cites a study by Peter Orszag and Jason Furman (two economists associated with the Obama administration) that shows how corporate profitability has become less equitable. In 1982, 90th percentile results for return on invested capital with nonfinancial S&P 500 companies was 22%, as opposed to 9% for the median and 6% for the 25th percentile. In 2014, those figures were 99%, 22%, and 6%, respectively.
While the median growth from 9% to 22% is impressive--if not entirely unexpected, as 1982 was a trough year for profits and 2014 will likely prove to have been close to a peak--the change in the 90th percentile is far more remarkable. From 22% to 99%!
The top companies are mostly as you would expect: technology and pharmaceuticals. The intangible assets of "technology standards, patents, and networks of customers or suppliers" have permitted those firms to increase their margins, even as conventional economic theory predicted erosion due to competitive pressures. (CAPM is not the only Nobel-winning economic theory to fail the test of evidence.)
This, of course, is a global effect. The giant technology and drug firms have worldwide businesses, frequently accruing more revenues abroad than at home. Thus, American politicians--and American politics--are largely irrelevant. Google’s profits depended not on the outcome of the 2008 and 2012 Presidential elections, and they will not depend on the 2016 election, either.
Location, Location, Location The trend in income inequality flows naturally from the success of the multinationals. As Apple, Google, Microsoft, and Facebook (all examples from Ip's article) have accumulated ever-larger profits, they have invested back into their employees--and not just into their top executives or highly trained computer scientists but also across the employee base, including the support staff. Ip reports that Facebook recently raised wages for its cafeteria staff to $15 per hour.
The trickle-down effect on wages among the technology and drug companies echoes the policies of Wall Street, which not only awards famously high salaries to senior employees but also pays its administrative assistants 40% above that occupation’s national average. In short, those who work at elite, highly profitable companies have done well across the employee base. They’ve gobbled up the nation’s salary growth. Meanwhile, those who work at mundane firms have been left behind. Their salaries have sagged, along with their companies’ relative fortunes.
Ip cites a study by Jae Song of the Social Security Administration and four co-authors claiming that substantially all the reported growth in U.S. income inequality owes to the corporate effect. In other words, with the very small exception of the very highest salaries (CEOs, basically), the increase in income inequality is not because companies have changed their labor policies to give more to the rich and less to the poor. It is because the companies themselves have been relatively more rich and relatively more poor.
Admittedly, Song's result is on the extreme end, as other studies have found that up to one third of income inequality owes to factors other than the corporate effect. Nonetheless, it seems pretty clear that most of the conventional debate about the cause of income inequality, and its purported cures, is balderdash.
Lessons 1) U.S. stocks might be enough. Perhaps, per Jack Bogle's oft-derided argument, U.S. investors need not diversify into international stocks. After all, the dominant U.S. businesses are also dominant international businesses. If the world outside the U.S. fares well, those companies will also fare well. And if the dollar declines in value, their overseas profits will increase in dollar terms; those companies are, to an extent, self-hedged.
2) This time might be different. With, as always, the emphasis on "might." Only the very brave or foolhardy will discard nearly a century's worth of stock market evidence showing that value stocks are a better long-term bet than growth stocks. I do not claim such courage and hope not to be so reckless. But there is a chance that growth stocks will lead the way over the next five years, as they have done for the past half-decade. At least within technology, the biggest winners appear to be strengthening their positions, not losing them. Those handful of global leaders might carry growth stocks on their backs for a few more years.
3) Tell your children that it matters less what they do, than where they do it. From Peter Orszag, "As former Google chief executive officer Eric Schmidt once said to Cheryl Sandberg, now the chief operating officer of Facebook, 'If you're offered a seat on a rocket ship, don't ask what ship. Just get on.' "
Postscript: The hot asset class did indeed remain hot, and this time (as represented by November 2015) was indeed different. In the five years since this column was first published, Morningstar's Large Growth Stock Index has gained 18.91% annualized, as opposed to the Large Value Stock Index’s 8.38%.
Were I to rewrite this column today, I would say much the same about the business prospects of growth companies. The fundamental story remains intact; the rich companies continue to become richer, due to global effects that transcend U.S. policies. However, I am less sanguine about such companies' investment prospects. The leading growth companies are considerably more expensive today than they were in November 2015.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.