Large growth stocks are winning the battle this year...by a lot. The Russell 1000 Value Index is down -7.3%, while its Russell 1000 Growth Index counterpart is up +2.6%. That's a return differential of 9.9%! Like any other investment, its important to understand what drives returns of these respective indexes. Classically, the distinction between a growth stock and a value stock is based on the relationship between a company's book value and its market price. Book value represents the difference between a company's assets and its liabilities. Think of it as the net worth of a firm.
One would think that buying stocks that are inexpensive relative to book value (low price to book ratio) would outperform. But, sometimes expensive prices relative to book value (high price to book ratio) are warranted if an investor believes that the stock has out-sized potential in the growth of its business. Historically, stocks that are cheap relative to their book value outperform, but this year is an exception. The chart below divides the large cap investment landscape into expensive (growth) and cheap (value) stocks by price to book in a similar methodology as the Russell indexes. You can see that on average growth stocks have delivered a 4.5% return while value stocks have delivered a -11.5% return. What gives?
Below are the five "reasons" why growth is beating value.
These 5 tech heayweights (treating Google Class A and C as one) have done exceptionally well this year. That's the good news, if you have owned them. The bad news is that caution is required. Any new money going into these stocks should be done with a healthy does of skepticism. We all love the latest and greatest technologies, but sometimes good companies don't make good investments. Investing is all about the price you pay, and these companies are more expensive than a McLaren F1. Using a combined ranking based on earnings, sales and cash flows, these stocks are on average more expensive than 90% of large stocks in the U.S. Stocks that fall into the most expensive 10% by valuation historically go on to underperform the market by -6.4% per year.
Not only are they expensive, but some of the firms are massively diluting shareholders through enormous stock option packages to executives and employees. Facebook (FB), for example has diluted shareholders to the tune of 9% of its market value over the previous 12 months. This trend is rampant among social media darlings. Twitter (TWTR) issued $170 million in 3Q 2014, 47% of its market value at the time. Be wary of companies lining their pockets with shareholder dollars.
So why are these companies so appealing? In a word... growth. In a low growth world, which we have experienced since the credit crisis, rapidly growing industries are enticing. The possibilities for blue skies are endless if these firms can just figure out how to turn all those ad sales into earnings, which by the way, they have not yet.
But all good things come to an end. While these tech darlings have rocketed up on average 42.9% year to date, the rest of the growth index has declined on average -0.9% over the same period. Growth has been leading value for several years and the cycle may be beginning to turn. The chart below shows rolling 3 year returns from 1975 through 2015. The blue represents periods when value stocks outperform. The red represents periods when growth stocks outperform. Just as stocks and bonds come in and out of favor, such is the same with value and growth stocks.
My message... don't get caught in the social media hype. Require the stocks you own to be priced appropriately and be mindful of the fact that todays innovation is tomorrow's mediocrity. What has worked the last few years, may not work for the next few years.