The Tortoise Catches the Hare


Many of us are familiar with the fable about the tortoise and the hare.  They race, the speedy rabbit jumps out to a quick lead, takes a nap when he appears confident of victory, but is eventually bested by the slow-moving turtle.  The moral of the story is typically described as slow and steady wins the race, but one can also view it as a cautionary tale about overconfidence.  Believe it or not, equity markets are offering us a real-life version of that tale.

There are popular indices that offer us their own version of this dichotomy.  The folks at S&P Global (SPGI) have created market-capitalization weighted sub-indices of their flagship S&P 500 Index (SPX).  All the stocks in SPX are defined as growth, value, or some of each.  The pure growth stocks are placed in S&P 500 Growth Index (SGX), the pure value stocks go into the S&P 500 Value Index (SVX), and those with both characteristics have their market caps distributed between the two. 

The primacy of the growth sector was considered a foregone conclusion for much of the past few years.  Yet those who were overconfident about growth stocks throughout the post-Covid rally might be surprised to find that the stodgy value sector had nearly caught up by last Friday.  The chart below shows the normalized performance of SGX vs. SVX from the March 23, 2020 lows to last Friday.

SGX (blue/white) vs. SVX (blue), Normalized Daily Prices from March 23, 2020 to May 6, 2022

Source: Bloomberg

After a long period of underperformance and sideways movement for the better part of the last year, we now see SGX outperforming SVX by 1.8% since the lows.  The indices are calculated on an end of day basis, so it would not be surprising to see that differential shrink further – or evaporate entirely – if current market levels hold.  Either way, investors would not be wrong to wonder whether the slightly better absolute returns of growth were worth the increased volatility.

Also bear in mind that SGX and SVX are comprised only of SPX members, and note that SPX has significantly outperformed indices like the NASDAQ 100 Index (NDX) and Russell 2000 (TRY) on a year-to-date basis.  Bottom line, there are more speculative growth names that are not in SGX that have significantly underperformed that large-cap index.  What went wrong?

I hate to blame the Federal Reserve and Congress, but we need to acknowledge that the record levels of monetary and fiscal stimuli created an incredible period of financial excess.  We can debate the policy merits about whether that amount of stimulus was necessary, but it is important to remember that the definition of inflation is too much money chasing too few goods.  Until recently, the goods that were being chased most aggressively were financial assets.  Since the end of the global financial crisis in 2009, we have seen relatively uninterrupted monetary accommodation.  We were quite fortunate that the only sustained inflation was in financial, not real-world assets.  It was logical to assume that the pattern would hold during Covid, and it did – until it stopped thanks to war and supply chain issues. We now see a reversal of that accommodation to combat real-world inflation, and that reversal is leading to a global repricing of assets.

We can look at the damage among dubious investments, like SPACs, but I find stocks like Shopify (SHOP) more instructive.  That was a marginally profitable company that hit its stride during Covid.  It became a stellar outperformer, but began to stumble even before its recent quarterly loss.  The stock is down about 80% from its highs, but is still worth over C$50 billion and sports a forward P/E above 200.  Is the decline the fault of SHOP, or the crazy valuation that investors placed upon it?  I’d assert that most of the blame falls upon the latter.

Here are three themes that define the excesses that we saw in investors’ love of speculative growth stock:

  1. Disruption is a means to an end, not a goal in and of itself.  Many of our greatest companies were disruptors at one time or another.  Microsoft (MSFT) disrupted the computing industry, for example.  But those companies found a path to sustained profitability.  Being a disruptor without a path to profitability ultimately does little good for investors. (Think Uber and Lyft)
  2. Price/Sales is a lousy metric.  Yes, companies need to grow their revenues if they hope to grow their profits.  But sales without profit or cash flow is unsustainable.  I am reminded of an old joke where one partner in a business notes that they are losing money on every item they sell, and his partner responds, “yes, but we’ll make it up in volume.”  I believe that was the rationale for many investments recently.
  3. If real rates are zero or negative, one can discount future cash flows to infinity.  If we accept that a stock price represents a share the future cash flows and/or earnings that a company will earn, lower interest rates lead to higher net present values.  If we use an interest rate of zero or less, we can rationalize any value we’d like.  And many investors did.

Does this mean that value stocks are poised for an extended period of outperformance over growth?  Maybe, since we don’t appear to be close to fully unwinding the monetary stimulus that led to growth’s valuation.  But if we consider valuation and the dispersion of returns, slow and steady does appear to be in a good position relative to fast and furious.

Disclosure: Interactive Brokers

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