Yes. Tech’s ascent this cycle has seemed extraordinary, but growth in the sector has been somewhat comparable to recent market cycles. Furthermore, although technological developments tend to be associated with fast-growing firms, value companies that continually adapt and incorporate new technologies also benefit, by remaining competitive and cost-efficient. One important challenge to value outperformance is that standard accounting metrics provide a distorted representation of corporate economics, rendering the price-earnings and price-to-book ratios that index providers use to define growth and value less meaningful. Dividend discount model analysis and other valuation tools can provide more robust measures of value.
Though the growth in tech stocks has seemed nothing short of spectacular during this market cycle, the sector’s earnings growth from the trough through today has been similar to that experienced in the last market cycle. Since October 2009, US tech stocks’ earnings have grown a cumulative 258%, comparable to the 251% growth experienced from 2001 to 2007—a period in which US value stocks trounced growth, which had become massively overvalued during the tech bubble. Tech earnings growth in both of these cycles fell far short of the seven-fold increase seen from 1991 to 2001. Furthermore, the rate at which tech earnings have outpaced the broad market is also comparable to the gap seen in the last cycle. An examination of global equities reveals similar dynamics.
Primarily due to sector effects, value indexes have underperformed growth indexes. With sector differences neutralized, growth and value indexes are performing neck-and-neck. Sector differences across MSCI World growth and value indexes account for 90% of value’s underperformance since 2007, with poor performance from financials, in the aftermath of the global financial crisis, generating much of the negative attribution. Over the last five years, technology accounted for almost 30% of sector effects, while financials and energy together accounted for 40%.
Relative performance of these three sectors is key to the revival of value indexes. Clearly, financials and energy have faced significant headwinds this cycle, while the tech sector has boomed. Will this continue indefinitely? We think not. Clearly, the nature of these sectors has evolved. Large energy stocks face pressures from technological innovations like fracking and horizontal drilling; the financial sector has had its wings clipped by regulatory constraints that have reduced its profitability and helped non-bank competitors gain market share. At the same time, advances in the tech sector have been broad based, building on many of the developments of the 1990s tech innovation wave.* Technological innovations can help financials and energy firms to compete and grow—their benefits are not limited to the tech sector. For example, banks are reducing their cost structure, replacing costly branches with more convenient online and mobile banking, and tools like artificial intelligence and big data could improve loan screening and enhance banks’ ability to market new products. Banks that embrace these technological developments should fare well. However, some of tech’s leaders are vulnerable to regulatory backlash and trade conflicts that may make it difficult for them to sustain strong earnings growth and high profit margins.
A final consideration is the degree to which accounting metrics may be responsible for underperformance of value indexes. Much has been written about the distortions caused by the treatment of intangibles, including research & development, brands, intellectual property, and the like. Spending on intangibles is expensed immediately in the income statement rather than depreciated over time. This practice, designed in an age of industrial company dominance, reduces the information content of earnings and book value in companies that have large intangibles, making such companies appear more expensive. Because of this distortion, index funds that define growth and value by using P/E and P/B metrics exclude many companies with high intangibles from the value indexes. Active value managers that have recognized this distortion have the ability to enhance returns by investing in good values that are excluded from the value indexes.
Growth stocks may continue to outperform value for a bit longer this cycle, but we think it quite premature to declare the death of value. Tech has performed quite well and its reach has grown, but its growth thus far this cycle has been similar to recent cycles. Benefits of improved technology will accrue to many sectors, not just tech firms. On a sector-adjusted basis, value and growth performance have been neck-and-neck. Finally, relative valuations for value compared to growth—as imperfect as such metrics are—have fallen below the 10th percentile, levels that historically have presaged reversals.
* Please see “Rising from the Ashes: Key Developments Since the Global Financial Crisis,” Cambridge Associates Research Report, 2018.
Celia Dallas, Cambridge Associates’ Chief Investment Strategist