Since Parsec’s founding in 1980, we’ve touted the benefits of long-only equity investing. This includes owning individual stocks, mutual funds, and exchange traded funds (ETFs). We’ve also maintained the same investment style over the last thirty-seven years. Regarding funds, Parsec’s investment policy committee (IPC) focuses on low fees, higher-quality holdings, and managers with long track records of outperformance. When researching individual stocks, we take a value approach, favoring higher-quality companies that trade at a discount to history or peers.
While history shows that value stocks have outperformed growth stocks over most market periods, in recent years growth stocks have delivered higher returns. In this email we’ll discuss what we mean by value versus growth investing and why we believe value stocks are poised to outperform going forward.
Different stock investors define “value investing” differently. However, most agree on a few basic principles. In general, value investors prefer stocks that trade at discounts to their intrinsic values. Often this happens when a stock’s valuation falls below its long-term historical average or that of its peers. Another tenet of value investing is margin of safety. This means selecting stocks that can deliver healthy total returns even if current growth assumptions fall short of expectations. While we consider ourselves value investors, we will add select growth stocks to the Parsec buy list when expectations look reasonable and a company has a competitive advantage. In other words, when we think a stock has a reasonable margin of safety.
In addition to a value-based stock selection approach, Parsec’s investment philosophy also has a quality bias. This means we prefer companies with strong cash flows, consistent earnings growth, a long history of dividends, and above average returns on invested capital. We also favor companies with strong balance sheets that can withstand different market environments and even gain market share during difficult economic periods.
Looking back over the market’s history, value stocks have outperformed growth stocks by an average of 4.4% annually from 1926 to 2016 (Bank of America/Merrill Lynch). More recently from 1990 to 2015, value stocks outperformed growth stocks by just 0.43% annually. The spread has since reversed and in the last ten years value stocks have lagged growth stocks by 3% annually through the second quarter of 2017*.
The shift in leadership from value to growth stocks coincided with the start and continuation of the Federal Reserve’s massive monetary accommodation programs known collectively as quantitative easing (QE I, II, and III). Those programs put additional downward pressure on interest rates. In the face of low or no yields and the slowest economic expansion after a deep recession in over 120 years, investors demonstrated a preference for growth stocks over value stocks. They were willing to pay up for companies delivering higher growth in a world where growth had become scarce. Throughout the last ten years value stocks have occasionally outperformed, but usually in tandem with a steepening Treasury yield curve and thus improving growth expectations.
Because asset prices and interest rates are inversely correlated, very low interest rates over the last decade have led to above-average asset valuation levels. This has been even more pronounced among growth stocks as investors have been willing to pay a premium to own them in a slow growth environment. As a result, typically higher-priced growth stocks are even more expensive today.
Sticking to our value- and quality-biased investment approach has admittedly been a headwind in recent years. However, we believe higher-quality stocks trading at a discount are poised to outperform. Growth stocks currently trading at premium valuation levels will have further to fall in the event of a market downturn. As well, low interest rates have prompted corporations to take out record debt levels. As rates begin to rise, higher-quality companies or those with strong balance sheets and robust cash flows will be better able to service their debt levels, even during an economic downturn. While maintaining our investment approach through the current environment has been challenging, we feel confident that investing in higher-quality companies trading at discounted valuations will reward clients over the long-term.
*References the Russell 3000 Growth Index and the Russell 3000 Value Index
The Parsec Team