Profiting from the Cyclical Seasons of Growth and Value
Continually the airwaves rotate through the growth and value managers du jour, and like religious zealots each one explains their philosophy with such confidence that Jersey Shore’s “The Situation” would even call them cocky. The fact of the matter is that styles go in and out of favor like the seasons of the year. What’s more, the consistency of the seasons is erratic and the duration of the style outperformance can in many instances extend for years. A major driver behind the relative outperformance of styles links back to where we stand in the economic cycle. Since these phases can last for years, meticulous precision is not required.
Case in point, take the “Go-Go” 1990s. In the back half of the decade, while the “New Economy” of technology companies propelled GDP to new heights, growth stocks witnessed historic price appreciation and P/E (Price-Earnings) multiple expansion. As members of our growth team high-fived each other on a daily basis, the “Four Horsemen” consistently jumped 2-3% like clockwork. Simultaneously, human resources had to keep sharp objects away from our value team colleagues and make sure the windows were locked shut. As you can see from the chart, growth stocks trounced value stocks during that period.
Karma can be a bi*ch however, because as the technology bubble burst in 2000, the coiled underperforming value stocks sprang to significant outperformance in the first half of the 2000s. The value managers were more than happy to hand over the straightjackets to us growth managers.
Since these style cycles can persist for long periods of time, and we managers get compensated based on performance versus peers, there is a strong incentive to cheat or style drift towards the outperforming style (see also Hail Mary Investing).
The pain threshold is increasing for value managers as the economic expansion matures and growth stocks have handily outperformed value stocks over the last five years. When value managers start piling into Apple Inc. (AAPL), maybe the value cycle will be ready to kick into gear again.
Growth consistently outperforming value (Source: Russell Investments)
Arbitrary Style Buckets
Understanding the dynamics of style outperformance cycles is important, but understanding how the sausage is made at the micro level is essential too. One must appreciate that style categorizations are determined by arbitrary criteria by self-anointed “bucket deciders” (i.e., S&P, Barra, Russell Investments). Like ping pong balls, individual stocks will bounce around from one style bucket to the other based largely on share price volatility and financial metrics such as Price/Book, Price/Earnings, and EPS growth. Regrettably, these metrics can become temporarily distorted and lead to irrational trading patterns for benchmark hugging managers that become myopically focused on minor deviations from the herd.
Based on the stock bucket decision criteria, some questionable head-scratching stock categorizations may occur. For examples International Business Machines (IBM) is classified as a growth stock in the Russell 1000 Growth Index despite a cheap forward 11x P/E multiple, meager 3% revenue growth, and a 2% dividend. Phillip Morris Intl (PM) is also considered a growth stock even though its revenue growth has recently been even more sluggish at 2%, and has a mouth watering value-like dividend of 4.4%.
On the flip side, stocks like Microsoft Corp. (MSFT) are thrown in the value bucket, although the software king grew revenues +25% and earnings +55% in the recent quarter. Iconic value stock Berkshire Hathaway (BRKA/B) follows many growth stocks by not paying a dividend, and the Buffett controlled entity trades at a sky-high trailing P/E multiple of 20x, and ironically expanded sales and earnings by +21% and +28%, respectively.
All this talk of style seasons and bucket hopping only highlights the boring but crucial principle of diversification. It’s important to understand these cycles and categorizations, especially at extremes, but this does not get rid of the fact that an overly concentrated portfolio concentrated in an outperforming style is setting itself up for failure (see also Riding the Wave). We’ve reviewed cycle dynamics surrounding investment styles, but these varied securities come in all shapes and sizes – we will tackle the relative performance forces of small, mid, and large capitalization stocks during another season.
Wade W. Slome is a CFA and CFP® at Sidoxia Capital Management.
Disclosure: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and WMT, but at the time of publishing SCM had no direct position in any other security referenced in this article.