2020 has unquestionably been a weird year all around, but value investors have found it a particularly fraught one because it has demonstrated that the conventional method of value investing, in which cash flow and debt levels are carefully analyzed to determine the appropriate price for a stock, simple has not worked. This isn’t new; so-called value funds haven’t been working for a while, which is why the Vanguard Growth ETF (VUG) is up 506.8% since inception and the Vanguard Value ETF (VTV) is up just 267.6% over the same time period. Looking for value stocks has not worked for a long time, even if value seemed to have won over the dot com bubble that occurred just a few years before these funds got going. Plus, the gap has gotten bigger in recent months; 40% of VUG’s total returns have occurred in the last year.
Before we pronounce value investing dead, we first need to define growth investing and determine what is the difference between the two. This is crucial because they’re really not that different; both look at the fundamentals of a company, use modeling based on financial mathematics to project future revenue, expenses, and earnings of a company, and conclude that the fair value of the stock at any time period is a certain price. The math and process are very similar, so why are the two so often at loggerheads?
The answer is in the emphasis. Value investing focuses on profitability and extrapolates profitability based on past performance and a relatively static multiplier. A value investor will see a company has had a 30% net profit margin, will see that that same profit margin exists in competing companies, and conclude that the company is at fair value since its P/E ratio is similar to others in the market.
A growth investor does not care about profit in the same way–or, in extreme cases, at all. For a growth investor, profits come in the future after revenue growth has allowed the company to scale into profits, with billions of dollars of losses being completely acceptable at the beginning of a company’s lifetime.
Thus growth investors laughed when value investors pointed out Facebook’s (FB) lack of profitability in its early years; as a result, growth investors in a company that went up over 6x in eight years from its IPO. Now Facebook is a reasonably mature tech company, a major component of the major indices, and has a market cap of $787 billion and a P/E ratio of 33, relatively in-line for a tech company of its size and growth rate.
And FB is one of growth investing’s less successful bets in recent years!
Of course, growth investors can and have erred too much in eschewing profits, with some notorious disasters like WeWork in the dustbin of history. Those disasters, however, have tended to remain in the private sector, and even the less successful growth stories of the last few years such as Uber (UBER) have not lost investors money from the date of IPO to today. The biggest excesses have remained in the private market, with the IPO barrier stopping too bubbly growth investor expectations from bleeding into the public market (although, of course, there are exceptions).
One could say that the entire structure of the market has evolved to be more growth focused. As a result, growth investing is more successful as the big duds don’t become public or, if they do, are not so overvalued as to overshadow the wins like FB. It is possible that new developments could change that. The special acquisition company (SPAC) route to IPO is very new and untested, and it has introduced some disasters in its early days like Nikola (NKLA). More disasters may be forthcoming.
But for now, the market seems to have redesigned itself to be more focused on growth than value, and that may mean value investors will have to change their way of thinking–although their ways of valuation clearly have value for avoiding some of the biggest disasters in hype companies.