Benjamin Graham noted that successful investing requires the “patience to wait for opportunities that may be spaced years apart.” But once those moments arise, it also demands the discipline to stick with them as they unfold over time. That’s a crucial point today’s investors need to remember.
After waiting fifteen painstaking years for value to start outpacing growth—which began to take place at the start of last year—some investors are already turning their backs on the nascent rebound. As interest rates have normalized, you hear conversations where people wonder out loud if they’ve missed the rally. You see this in headlines, such as this one from CNBC: “It’s Too Late to Chase Value, So Get Into Growth Stocks Instead…” You can also glean this from fund flow data.
In November, the exchange-traded fund with the biggest net inflows was Invesco QQQ Trust ("QQQ"), which holds some of the largest growth stocks by tracking the Nasdaq 100 Index, nearly half of which are tech. Never mind that QQQ was down more than 25% over the past year through Nov. 30. By contrast, the ETF with the single-biggest outflows was Vanguard Value ETF, despite generating positive returns over the past 12 months.
The same thing took place shortly after the bursting of the dotcom bubble in 2000, when small value began to outshine mega-cap growth. A mere year into the tech wreck, some investors who felt late to the value cycle assumed they missed their window and chose instead to bet on large growth stocks, which they mistakenly assumed were bargains just because their share prices had fallen.
That turned out to be a loser’s bet. Those who invested in stocks found in the Standard & Poor’s 500 Information Technology® Index a year into the 2000 bear lost 29% cumulatively over the next five years. By contrast, those who remained patient and continued to invest in small-cap value gained 89%, based on the Russell 2000 Value® Index from the start of 2001 through 2005.
For today’s investors wondering if it’s too late to embrace value, that experience should offer an important clue. Growth and value tend to take turns leading the market, but the cycles often last years, not days.
It also highlights an important point: Value investing and “buying on the dips” are not the same thing. Just because popular growth stocks that were once the market’s darlings are down considerably from their peak doesn’t mean they’re cheap. Or cheap enough to make them worth buying. They likely have more room to fall.
Looking back at 2000, investors who bought beaten-down growth stocks on the dip were not thinking like true bargain hunters. As the father of value investing noted, the intelligent investor focuses on the fundamentals and is always conscious of building in a margin of safety to their strategy, a theme that is reflected in Heartland’s 10 Principles of Value Investing®.
At the end of 2000, small- and mid-cap value were still more attractively priced than large-cap growth, even after tech’s big losses. For instance, the S&P 500 Information Technology sector’s earnings yield—which measures the earnings per share generated by an investment divided by the price per share—stood at 3.1%. That was well below the 7.4% earnings yield for the Russell 2000 Value Index (see table below).
Source: FactSet Research Systems Inc. and U.S. Department of the Treasury, data as of 12/31/2000 and 10/31/2022. The data in this chart represents the earnings yield and the market risk premium (MRP) for the Russell Midcap Value Index, Russell 2000 Value Index, S&P 500 Index, and the S&P 500 Information Technology Index (“Tech Index”). The market risk premium (MRP) is defined as the additional return that’s expected on an index or portfolio of investments above the given risk-free rate. In the chart above, the MRP is calculated by subtracting the 10-Year Treasury rate from the earnings yield of each Index, as of the stated date. All indices are unmanaged. It is not possible to invest in an Index. Past Performance does not guarantee future results.
Perhaps if Tech Index's earnings yield had been higher than the interest rate paid by “risk free” assets like Treasury bills, they might have had some appeal. But that wasn’t the case. Tech Index's earnings yield in December 2000 was 2 percentage points lower than what T-bill were paying; in other words, its “market risk premium” was negative. Why would anyone bet on an investment exposing them to heightened market risks when they could earn more from riskless cash? An important point to consider as we come out of a prolonged period of abnormally low rates.
Fast forward to today — impatient investors who are thinking about buying beaten-down growth stocks should consider that the situation may be similar to the dotcom bubble era. The market risk premium for tech stocks is again negative. Meanwhile, with earnings yields of 10.5% and 7.4%, respectively, for stocks in the Russell 2000 Value and Russell Midcap Value Indexes look far more attractive than large-cap tech, even after the 2022 slide.
This emphasizes why investors must avoid acting on gut instinct and instead focus on the fundamentals, especially at a time when market risks are on the rise.