Finding the Middle Way between Growth and Value
Growth stocks have outperformed their value peers by a wide margin in recent years, but there are important risks to consider on both ends of the growth-value spectrum. Portfolio Manager Brian Demain explains why investors should consider a “middle way.”
- In the race to dominate nascent industries, many growth-oriented companies are spending aggressively to achieve network effects.
- At the same time, some value-oriented companies are hindered by legacy business models that may ultimately render them obsolete.
- Faced with these two extremes, investors may be well served to focus on companies in the middle ground.
The growth-versus-value dynamic in equity markets has reached parabolic proportions. Over the past five years, large-cap growth stocks have outperformed their small-cap value peers by an average of 10% per year. This is a stunning gap that flies in the face of the conventional long-term investing wisdom underpinning many smart beta strategies: that value outperforms growth and small cap outperforms large cap.
The drivers of this significant disparity are well-documented. Rapid technological innovation is a powerful force disrupting virtually every industry, harming the earnings power of many value stocks. Meanwhile, the impact of network-effect economics is equally profound, allowing for tremendous value creation at some growth companies.
The Growth Challenge: Chasing Network Effects
Put simply, the network effect is what occurs when increased numbers of people use a product or service and thereby increase its value (the Internet is perhaps the most obvious example). Companies that recognized and embraced this phenomenon early have disrupted industries, stomaching short-term losses to cement long-term network effects – often with stunningly positive results.
Consider what has been dubbed “the Amazon effect.” In the 2000s, many investors viewed Jeff Bezos’ decision to lose $1 billion per year for a decade as a completely irrational decision. It later became evident, however, that those losses were helping establish a network effect and sow the seeds of retail disruption. Today, that approach to scale is seen as good business because Amazon’s network effect has ultimately established one of the world’s most valuable companies – the second after Apple to reach a trillion-dollar market cap.
As the investment community begins to appreciate the potential value of scale and network effects, it almost seems rational for companies to spend billions and billions of dollars to try to capture network-effect economics. And we are seeing this strategy adopted across multiple nascent industries, from ride hailing and food delivery to enterprise collaboration software and digital banking.
In our view, however, network effects are unlikely to continue driving the same returns among growth stocks as what we’ve seen over the last decade. Many of these markets have two or more players fighting for scale, and incumbents are responding. So while there may be a winner in food delivery or e-banking, how much will those companies need to spend to achieve profitability and what will the return on that investment be? We believe those companies that are racing to capture network effects are following a rather tenuous path to growth, making them potentially risky bets for investors with longer-term horizons.
Value’s Legacy Problem
At the other end of the spectrum, value stocks remain truly challenged. As we go down the list of public companies today, we think many may have no reason to exist five or 10 years from now. These firms are built on legacy competitive “moats” around distribution, information asymmetry and regulatory barriers. In a more transparent, data-rich economy, these moats are shrinking – and quickly. Of companies that do survive, many could see their return on invested capital – and correspondingly, their price-to-earnings multiples – drop precipitously.
Taking the Middle Way
So what are investors to do? In our view, the answer could be to avoid extremes and pursue what we call the middle way: identifying businesses that are not spending aggressively to chase massive yet unproven opportunities but are also not value traps clinging to legacy business models. Oftentimes (though not always), these firms are in somewhat capital-intensive industries where the companies earn a strong return on capital, but not so strong that it attracts disruptive competition. And although many of these companies are not technology firms, they are embracing technology to improve their businesses. These businesses also tend to have acceptable growth and reasonable valuations. By taking this middle way, investors may be better positioned to find opportunities with sustainable risk-adjusted returns.
Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.
Actively managed portfolios may fail to produce the intended results. No investment strategy can ensure a profit or eliminate the risk of loss.
Growth stocks are subject to increased risk of loss and price volatility and may not realize their perceived growth potential.
Value stocks can continue to be undervalued by the market for long periods of time and may not appreciate to the extent expected.