Mind the GARP – Growth At a Ridiculous Price
“What we learn from history is that people don’t learn from history” – Warren Buffett.
During a bull market, one tends to make most money at the beginning when sentiment and prices are depressed, and then towards the very end when optimism temporarily outstrips fundamentals.
On a risk-adjusted basis, one is clearly best-advised to carry more risk early in the cycle. This is where, more often than not, gains can be retained, rather than at the end where they are quickly surrendered once animal spirits are disrupted.
In practice, most investors tend to be risk averse at the beginning of the cycle and exceedingly confident at the end (hence their willingness to speculate in the face of already high prices). Even those who observe that risks are building often feel unwilling or unable to de-risk their portfolios for fear of missing out on any eleventh-hour gains.
Beware the bandwagon
At this stage of the cycle, we have always placed a great deal of emphasis on assessing valuations in the context of history. We do so because in the long-run, valuations are by far and away the most important determinant of future returns (even if in the short-run they can prove frustratingly meaningless). We also dedicate a lot of time and attention to understanding investor expectations and appreciating where capital is concentrated at any particular time.
Crudely, when we see a trifecta of extreme valuations, very high expectations and intense capital concentration, one wants to be very cautious about jumping on the bandwagon. This is where the US stock market, and its growth assets in particular, find themselves today.
Consider that in the past year-and-a-half, the market cap of the S&P 500 ballooned by $6 trillion. Half of that was in the tech sector and half of that in the five FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) stocks alone. So much money chasing so few names is classic late-cycle behaviour and driven more by speculative psychology than fundamentals. In October, the FAANG stocks fell into a bear market and the Chinese internet names have already been there for a while. These are all important hallmarks of a shift in the investment environment.
When, not if, valuations matter
The challenge with periods of excessive valuation is not that they’re difficult to identify (if you care to look beyond a simple P/E ratio), but that by definition they can only emerge if the majority of investors are willing to dismiss them.
We have been here before with growth stocks, both in the mid-70s (Nifty Fifty) and the late 90s (tech bubble). In both cases the argument was evidently not whether valuations are important, but when. Similarly, in both cases, being out early was ultimately preferable to overstaying one’s welcome.
Having spent our careers analysing fund managers, what’s patently obvious is that like most things in finance, relative performance is cyclical. Sometimes that cycle is driven by skill, but often it is driven by style. We have been overt proponents of the value style for a couple of years now, but for the majority of this bull market we were not.
A more permanent feature of our investment style is to be conservatively contrarian - that is to say we are typically sceptical of new paradigms and consider mean reversion to be a powerful force in markets, even if it takes time to unfold. Fundamentally, this is driven by a belief that investors ultimately seek out cheap assets to buy and expensive assets to sell.
Today, the US trades at almost double the price/sales multiple of the rest of the world – a premium ten-times larger than its historical norm.
Passive-driven, momentum-driven, computer-driven markets have been like kryptonite for contrarians of late, as price trends have been more important than price levels. The technology sector in particular has had an outsized impact on establishing this premium for US equities relative to the rest of the world, as well as the uninspiring performance of many active managers, ourselves included. Evidence is accumulating that its leadership is now fracturing. If true, it could herald a dramatic reversal in many of the trends of recent years.
The derating of growth stocks and mean reversion in favour of the value style represents a genuinely attractive opportunity in our view. Value has just endured its longest ever period of underperformance against what’s in vogue, and is historically cheap. As we all know, fashions change, and this one will be no different.
Our full quarterly note is available below.
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