Pricey growth stocks have been all the rage in 2017, running circles around cheaper value plays. We believe that one of the most powerful forces in investing, reversion to the mean, may cause value stocks to outperform in 2018. Position your portfolio accordingly.
Understand the Difference Between Value and Growth
Growth stocks are typically more expensive than value stocks. During bull markets, investors pay up for rosier growth prospects. Value stocks have more challenged growth prospects; investors are only willing to pay for their current results, not their future outlook. A recent Bank of America study shows that since 1926 value stocks have outperformed growth stocks, with value having an average annual return of 17% versus just 12.6% for growth.
Value Stocks’ Advantages
Value stocks typically pay more of their earnings out as dividends. Dividends can constitute up to 40-50% of a stock’s total return, so this profits payout helps value’s performance. Investors regularly err in their forecasts. Growth investors risk having their optimism thwarted, while value investors can be pleasantly surprised if the future is less mediocre than expected.
Reversion to the Mean: A Powerful Investment Phenomenon
Stock prices have a historical tendency to retrace prominent moves. Timing those reversals is difficult.
Reversion happens for both fundamental and technical reasons. Any successful business attracts competitors. Outsized profits spur price competition. Investors are also responsible for reversion. Many are momentum oriented, willing to keep chasing those investments that are “working” and continuing to advance. Investments are made first. Hard analysis comes later, as few want to argue with the market’s increasingly positive verdict.
However, no tree grows to the sky. Similarly, no stock can forever shake free of valuation’s gravity. Eventually, skeptics surface, betting against the valuation disconnect between the stock price and the fundamentals. The stock backs off, and investors start to cheerlead the new direction in the price, until another reversion sets in.
Energy: Today’s Classic Value Play
Energy stocks may be the best way to play mean reversion and a trend back toward value. On a fundamental basis, energy stocks are cheap, priced on the value of a commodity that’s close to half its 2014 peak.
Energy is also out of favor given the apparent absence of inflation. However, inflation, too, is cyclical. Inflation declines during periods of tight monetary policy; later, low rates and easy money give way to rising prices, first in financial assets, and later in the real economy. Energy, as an inflation sensitive commodity, is an ideal way to play the odds of greater inflation.
Health Care Stocks: Yesterday’s Classic Growth Sector Now Finding Favor with Value Hunters
Healthcare stocks have historically been quintessential growth plays. Investors paid up for the growth opportunities available amid an aging population and international demand. Research and development pipelines offered further profit possibilities as new discoveries promised potential monopoly profits under the patent laws.
Periodically, healthcare stocks have swooned and become value stocks, most often when government oversight threatens. Recall the proposed Clinton-era healthcare overhaul and the early reaction to the Affordable Care Act. Both times, healthcare stocks bounced back as the concerns proved overblown.
Recently, healthcare stocks have become quite depressed. Valuations have been slashed on many healthcare stocks, particularly for specialty pharma and generic producers. This has converted many names in this sector from Growth to Value plays. The potential upside should the ill winds from Washington, DC die down seems to far exceed the downside risk if the already much feared regulation occurs.
FAANG Stocks: Beloved Growth Plays
One group of stocks, known by their moniker of FAANG, are today’s Growth stock darlings. The cohort consists of Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Alphabet (GOOG), the new name for Google. They could be subject to profit taking in any swing from growth to value.
Save for one, Apple, none of these stocks pays a dividend, and Apple’s is very modest. All of these companies play in the high growth internet and “cloud” space, and their valuations reflect it, as they trade anywhere from 16 to 100 times earnings. These companies have had an outsized influence on this year’s advance of the S&P 500.
Each of these companies faces intense competition, as numerous rivals jockey to siphon off any margins available. Governments worldwide are investigating anticompetitive behavior. Facebook is receiving intense scrutiny over the source of its content, after it conceded that Russian interests posted numerous misleading and “fake” posts on its website in the last election.
Investors seem to disregard these hurdles for future growth of these companies. That, coupled with changing sentiments, may cause a period of underperformance for these names in the inevitable cyclical shift to value investments.
Note: David G. Dietze, JD, CFA, CFP™ is President and Chief Investment Strategist of Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Avenue, Summit.
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