When it comes to active equity management, growth stocks have outperformed their value peers — and at least one manager thinks that trend will continue, and not just for cyclical reasons.
Brad Neuman, senior vice president and client investment strategist at growth-focused investment firm Alger, argues that growth stocks have persistently outperformed value stocks over the past decade as a result of a slow growth environment and speedier innovation, based on his own research. What’s more, says Neuman, a key metric for choosing value stocks — book value, or a company’s assets minus its liabilities — is becoming less relevant than it used to be in choosing how to value companies.
That’s because research and development is not capitalized in book value, the traditional measure used by value investors, he says. He notes that tech companies like Alphabet or Amazon often have fewer assets on their balance sheets than a company like General Motors, which requires manufacturing plants and large offices to operate. While tech giants often spend significant money on research and development, this isn’t captured in the book value, he said.
According to Neuman, spending on intangible assets has increased, but it’s not captured on a balance sheet, and thus not in the price-to-book value of a company. As a result, many value investors are losing out on major tech stocks.
“The nature of businesses is changing,” Neuman tells Institutional Investor. “Accounting measures aren’t keeping up.”
Companies like Netflix, Facebook, and Amazon have exploded as consumers have quickly adopted their technology. This has, in turn, driven the NASDAQ — which hit an all-time high this week — even higher.
The Alger research showed that U.S. stocks with low price-to-book value have fallen roughly 20 percent since 2007, signaling that book value is becoming a less relevant measure in stock picking.
“Valuations aren’t working in the same way as they used to,” said Neuman.
Traditional value factor strategies of buying undervalued stocks and selling overvalued stocks — which before 2007 had produced an average annual return of 5 percent from 2007 — lost a cumulative 15 percent in value over the past decade, according to a Goldman Sachs report. By contrast, growth stocks in the Russell 3000 index have outperformed value stocks in the index by 45 percent over the past decade, according to an Alger analysis of FactSet data through June 30.
The dotcom bubble was the most recent cycle during which value investing fell out of favor. Internet stock prices soared, regardless of the technology behind what they did. Until, of course, the bubble burst. This time is different, Neuman argues, because tech companies are innovating at a faster clip than ever before. Rapid innovation by growth companies, including Amazon and Google parent Alphabet, is driving better returns, Neuman says.
“That’s a tailwind for growth stocks, but a headwind for value stocks,” he adds.
There are other factors at play. According to Alger research, decreasing consumer debt ratios and lower interest rates have driven up the value of growth stocks. The Goldman report noted that slower economic growth made growth stocks all the more appealing to investors.
“The fact that value has fared poorly in recent years accords with this cycle’s exceptionally slow growth and prolonged length,” according to the report, which was authored by equity strategist Ben Snider and others. The report’s authors noted that the “lower for longer” approach to interest rates encouraged investors to focus on growth stocks.
Lori Heinel, deputy global chief investment officer at State Street Global Advisors, argues that the swing toward growth investing won’t last forever.
“When the market is suspicious, you’ll see growth outperform,” Heinel tells Institutional Investor. “It shouldn’t surprise us that where the economic outlook remains pretty muted we see growth stocks do well.”
Heinel says these conditions could change when investors become more confident in the market.
“We’d make an argument that value will do better as we become more confident in the future growth outlook,” she says.