Growth or Value: Which Stocks Have the Upper Hand?

Transcript:

Stephen Dover: Matt, let's start with you. You wrote what I think was a really interesting piece highlighting the pitfalls of reversion investing, and also define the environment that we're looking at as the fourth industrial revolution. Can you give us the highlights of those articles and you're thinking?

Matt Moberg: Yeah, we recently wrote a paper called, “Did the Fourth Industrial Revolution Kill Mean Reversion Investing? We Think So.” And, the idea of this paper really came from a chart, which we have in the intro of this paper. And in this chart, there's this embedded argument that value has outperformed growth really between 1940 and 2010. That's a 70-year stretch, which in investing is pretty much as much of a sure thing as you can find anywhere.

So, the argument sort of goes well, we've had this crazy decade from 2011 to 2021 in which growth has clearly outperformed, but it's been to such an extreme that we're going to end up reverting back to value just like we did throughout the 20th century. Now, as growth investors, we love looking for change. And so, we're always on the lookout for items that defy consensus, beat expectations to the upside. And in our opinion, this 10-year outbreak is clearly something new. And so, we wanted to explore that, and that's really the point of the paper.

Stephen Dover: Can you talk a little bit more about the fourth industrial revolution, what that is, how you define it, and why you're, well, frankly, excited about the opportunities that it brings?

Matt Moberg: You know, the bedrock idea of value investing or one of them is this idea of mean reversion. And that's basically this idea that you can buy companies today with weak fundamentals and those fundamentals will mean revert, or they will experience positive change. There are a lot of examples of this in media and in oil through the 1950s, 60s, and 70s. But our argument is we're going through this idea, which is the fourth industrial revolution, which is very similar to the second industrial revolution. And just to review in the late 19th and early 20th century, we had these massive technological platforms developed. We had electricity and plumbing, and telephone and telegraph, and the anesthesiology and antibiotics, and the combustible engine. And as you can see, all these sectors hit society in all different industries: in health care, and transport, and telecommunications. And even food and factory, I mean, with refrigeration lighting, etc. It also led to an incredible amount of wealth creation. So, you had the Vanderbilts, and the Rockefellers, and the Morgans, and the Carnegies, etc, that all in a very short period of time create a tremendous amount of wealth. And so, we believe we're going through a period that's very similar today. We use Klaus Schwab's definition and he's coined it the fourth industrial revolution. Klaus Schwab founded the World Economic Forum.

And so, we've identified five platforms illustrative of the breadth of change occurring throughout the economy. And so, the five platforms we've identified is in disruptive commerce, and genomic advancements, intelligent machines, new finance, and exponential data. And if you think about those, those are also throughout the entire economy. And so, you have this period of time that we’re living in, where you have these incredibly young founders who have created trillion-dollar market cap companies, Brian Page, Zuckerberg, Musk, Gates, etc, and all those men are under 60 years old.

And then, all the companies they are creating are really replacing many of the great companies of the second industrial revolution. So, what we try to assert in the paper is that this time that we're living in, from a market perspective, is try to compare it to the 70-year periods from 1940 to 2010 is incorrect because the key ingredient to mean reversion investing is stable end markets. And back to, sort of, this original idea, like what happens to three TV stations, ABC, NBC, and CBS in the US when you have over-the-top programming? And what happens to oil once EVs [electronic vehicles] really become 25% to 35% of the auto fleet? And so, those are sort of the questions that we try to ask.

And so, we sort of have three reasons for this. We have the mechanical, the disruptive, and the hopeful, and it walks through what we think we’re seeing and why.

Stephen Dover: Thanks Matt. If you haven't seen some of these pieces that Matt’s written, I highly recommend looking at them.

Sam, you've also written some very interesting pieces and thought through this as a value manager. You work with a Big-Bang framework for market cycles, really arguing that every market cycle begins and ends with valuation extremes and a big change event, typically a crisis. So, maybe you can talk to us a little bit about your Big-Bang framework, but also how you look at revision to the mean, which is often a way that people think about value investing.

Sam Peters: So, I don't believe in equilibrium markets, and I believe that you go to extreme ends and tails. And I think, what I would take as Matt’s longer-term arc of frameworks and I break it into sort of shorter market cycles. And, you go back to 2000 and incredible innovation, that's when Amazon was born, you know, we're laying down fiber, we were laying all sorts of the bedrock for where we are now. And tech, you know, you had your tech bubble in a way. They called it then, at least, exposed. Mega-cap stocks got to extremes, which set up the SMID [small- and mid-caps]. And you were there, all that innovation continued. But then, you went through the cycle from 2000 to 2008, a new narrative emerged, which was Brazil, Russia, India, China, and suddenly, those stocks did incredibly well.  And I remember, in 2009, that you were transitioning again into a new market cycle, people expected emerging markets to come back, and commodities to come back as we were running out. And lo and behold, it set up this incredible cycle for growth.

And I think, where Matt and I probably wouldn't disagree on most things, but the initial conditions matter to me. And you had those valuation extremes. You had Microsoft at their valuation had gotten out 10-fold over the previous cycle. Yet, their sales had grown five-fold. And Microsoft was 12 times earnings at double digit free cashflow yield. All the things that became FAANG [Facebook, Apple, Amazon, Netflix, Google], no one wanted them. No one wanted big tech. No one wanted mega cap. And then, you set off this cycle.

And so, now, people are doubting the new thing, and frankly, it tends to be right now where the extremes are. This traditional value, financials, energy, etc, but everything goes to extremes. So, I want to be clear that all the value is for me as a measure of those extremes. And then if you get some change event, you can start at journey the other way. And I think we're, in my opinion, we're clearly seeing that, even within a longer arc that is framed very well by Matt.

Stephen Dover: Sam, that's really interesting: the cycles. And what my question would be is how do you look at that within value versus growth? Can you invest in those cycles as a value manager, or are you really recommending that advisors advise their clients to move back and forth between value and growth, depending on the cycle?

Sam Peters: Yeah. So, the way I feel, you invest anywhere. So, whatever gets to the extremes, whatever's left for dead, or, you know, you, you go there. And one thing is typically the fundamentals are getting better. So highest free cash flows in the market right now are energy, my companies that have been in winter, if you will, the fundamentals, it's actually, they're not junky, they're in pretty good shape. And so, you go anywhere where the valuations are, but I do think you need to see improving fundamentals, too. So, it's a combination of those two things, but over that, what I call a shorter market cycle, a shorter framework than Matt laid out, those 10 to 15 years, it's a new cast of characters. And I think over that time period, you do need to adjust at least tactically with what your positioning is.

Stephen Dover: Well, let's turn to a third view on that, and that's turning to you, Steve Lipper.

You have also thought this through and you’ve outlined four different reasons why you think there might be some opportunities in the smaller-cap arena right now.

Steve Lipper: Let me take the context around small-caps and the four things that we see about the conditions in the environment and where history may foreshadow some probabilities for the future. The first is around small versus large and the level of nominal GDP. You know, the research that we have done shows that there is a correlation between the level of nominal GDP, specifically a threshold at 5% and whether large or small-caps lead. I think most advisors will be aware that small caps are more cyclical-sensitive. And so, you would expect that small caps would lead when there's greater economic growth. And in fact, that's the history two-thirds of the time, small beats large when you're 5% or above nominal GDP.

And actually, in those environments, small delivers roughly double its historical level of return. But, let's shift down and continue to talk about the value versus growth within small cap. There is also a correlation on the level of nominal GDP and whether value or growth did well and it, sort of, speaks to this environment. If you look over the decades, the last decade has been one of low real, and low inflation, so low nominal GDP. And in periods of 3-5% nominal GDP growth, value has only won in small 32% of the time. But, when you've been above 5% nominal GDP value has won in small 70% of the time. So, one of the key inputs for any advisor thinking about their clients is to think about the upcoming environment, being aware of that correlation.

Two other points on why we think value in small is better set up the first is that, by our preferred valuation metrics, small value is cheaper relative to small growth than even at the height of the internet bubble. So, in more than 20 years, looking back over that period, the relative valuation of small is the cheapest that we have seen it. But, you need some catalyst for change. And this year we've seen that. And our fourth reason to be optimistic about value is its durability of outperformance in different regimes that we've already seen this year.

So, the first three quarters this year of small cap have been quite varied. In the first quarter, the small-cap index was up 13% and value beat growth, pretty handsomely. Then you had just a very modest 4% up in the second quarter and again, value beat growth. And in the third quarter, small caps are actually down 4% and again, value held up better than growth.

So for us, when we observe things over time and we see a persistence, a durability of outperformance, that gives us greater confidence that this extreme in relative valuation and what looks like a more supportive economic environment should tilt things towards small and towards value.

Stephen Dover: So, we're entering what is traditionally the small-cap season where small caps have outperformed, November-May, I think. But, we're also entering a period where it looks like we're having rising inflation and potentially rising interest rates. So how do you look at that, in terms of small caps, but also in terms of value versus growth?

Steve Lipper: Yeah, it's interesting and surprising to most people that we meet with that small cap has anti-duration properties, in that, when interest rates are rising, small cap does better than its history and nearly three quarters of the time beats large cap. By the way, when I’m referring to this, this is just the indexes, it’s the Russell 2000 versus Russell 1000. So, in that construct, nearly three quarters of the time of a rising 10-year yield on a one-year period, small-cap wins. Why is that?

Well, because interest rates don't usually rise by themselves. There's something else going on, which is often economic acceleration, which we've talked about, is that small caps tend to be more cyclical, value tends to be more cyclical sensitive. But then, there's a specific example in small value, which has a large percentage of regional banks. And when the yield curve is steepening, net interest margins are improving, and small cap and small-cap value tend to do very well. You also have a fair amount of materials companies and they'll have operating margin expansion that can meaningfully accelerate earnings growth. So, both in small cap, relative to large, and value, relative to growth, at least in small cap, are both beneficiaries of rising interest rates and modestly increasing inflation.

Stephen Dover: Matt, let's turn back to you. You've just heard some comments from Sam and Steve about, you know, in essence, their view that if we look at history, value is perhaps going to come back and that's the opposite of what really you're arguing in terms of being in a new environment.

Matt Moberg: There's so much to unpack there, I guess as far as, you know, the value to growth argument, first of all, we absolutely think that value will outperform episodically just like growth outperformed episodically between 1940 and in 2010. There were periods where growth outperformed. So, certainly, there are markets where things will go back and forth.

The other thing, though, I would mention is that there's this concept in innovation of what many people who study exponents called the second half of the chess board. And this is talking about how exponential growth works and this idea that if you go on a chess board and you put anything, you put a grain of rice on the first square, and then two grains of rice on the second square and four on the third, etc. There's 64 squares on a chess board. Once it gets about 62, you start getting into the trillions of grains of rice. But where things start to get really interesting is when you start going on to squares, you know, 33 to 64, and you're start experiencing all that doubling. So, what we would argue, sort of, what happened between 1999 and say 2011 we were experiencing exponential growth. We just happened to be on the first half of the chess board. I mean, Netflix was doubling regularly.

However, just go back to the media example, many of the TV companies were still posting very, very good numbers, both in advertising and in user numbers. Today, that's not the case. Nickelodeon, for example, has lost more than half of their audience. They've lost it to, you know, YouTube and they've lost it to Netflix. So, there comes this point where things get so large and they continue to be, sort of, the better mouse trap or the better business model, and it starts to affect the legacy business models. But, I actually don't want to suggest that everything is zero sum, because it isn't. A lot of times with new innovations you actually can sort of grow the market.

So, in ride sharing, for example, the convenience of being on your telephone and attracting a car, and being able to know where that car is and know what the price is and have that clarity has actually massively grown the market. You can still hail a cab in New York city. You can still try to call a cab in New York City and there's still great demand for cabs, but that is a technology which was so successful, it actually, sort of, brought the market to be four, five, six times larger than what it was before.

So, for brevity, I'll just, I'll simply stop there. It's not necessarily zero-sum, but we do think we're on the second half of the chess board.

Stephen Dover: How do you look at interest rates and rising inflation and how that might impact your thinking and portfolios?

Matt Moberg: We actually believe that competition for capital is very, very healthy in the market. I don't think a benign rising interest rate environment is bad necessarily for equities in general, value or growth from our perspective. What you really don't want to see are any kind of shocks. I believe this economy could still hum on US$140 oil, but it can't be US$140 oil tomorrow. It could be US$140 oil over the next, you know, five years or something like that. And I would argue it's the same for interest rates.

I don't think interest rates were really driving that level of change. And so, when we think about things like what's going on in genomics or other things, interest rates are not a primary driver. We think those advancements are going to continue and we think there are tremendous profit pools there. And so, in our opinion, we are not anxious over rising interest rates per se, but they just have to happen in a gradual fashion, in an organized fashion that's well signaled to the market.

Stephen Dover: Sam, let's turn to you and just ask the same question. As a value manager, how do you look at the potential for rising interest rates or the potential for higher inflation?

Sam Peters: So the challenge I think everybody's having is there's a little bit of macro infection into portfolios right now. And it comes if you do very traditional sort of value growth style, the correlation between interest rates and those styles has never been bigger; obviously, as rates go down, the growth style does well and vice versa when rates go up, the value style does very well, and it's never been so extreme. And then this comes back to where we started last year, which was value got to the hundred percentile, it was the cheapest ever as a style versus growth in history, in US market history, so 60 years. And so, you have these extremes and then you have the rates moving around from a macro standpoint. So at least for now, there's such a duration extreme, using a bond term where value has such short duration and growth has such long expectations, long duration to Matt's point for good reasons, because the innovations aren't going away, these companies that are have great competitive advantages, I don't disagree with any of that, but we need to unglue some of these extremes over the near term, in my opinion, before those correlations settle down and you'll get, you know, better stock picking from people in general, it'll be a good tailwind for people. I think we'll get there, but you've got to unwind some of these interest rate extremes and these duration extremes priced into assets, in my opinion. And obviously I want to be on the short side of duration. And if we end up with inflation or much higher rates, I agree with Matt. I don't think it's going to be runaway at all. He's spot on. You don't want to shock of any sort, and I don't think that's going to happen. But just rising off of this such a low basis, a lot of small numbers that delta change is going to be very big and we've got to unwind that a little bit.

Stephen Dover: Matt, let me ask you about ESG. When we're talking about the environment, that's of course, very tied to energy and energy markets changing. When we're talking about the S, the social side of it, that has a lot to do with labor. And finally, if we're to look at the G part of it, the governance, there's some ethical issues around some of the things that we might see going forward. So how do you look at this from both an investment point of view, a risk point of view and ethical point of view? How does ESG frame how you think?

Matt Moberg: I would argue it's really sort of trying to quantify a lot of qualitative things, which are very important. It's also not uncommon that with new innovations and we see this today in places like social media, etc, where the laws take a long time to catch up to the innovation. So, you can sort of start in a place where there's a lot of innovation, then over time, you know, the laws will start to catch up to that. The analyst team is having active conversations now with management teams about environmental, social and governance. And, it's becoming increasingly important and we welcome it.

Stephen Dover: Let's turn to you, Sam. Boy, value indexes typically have a lot of smokestack industries in them. Energy, historically, has been a very big part of value indexes. Yet I hear you talking about this being an opportunity as a value investor. So how do you approach ESG as a value investor?

Sam Peters: I feel you have to go in and drive the change. And I even have one of my energy companies that produces natural gas. They're doing US$75 million in alternative energy, and they're going to emission free, net zero by 2025, not 2050, 2025—that's engagement. That's what we're after, where we can do well for shareholders, but also hit the “E” and especially the “S” with governance by being engaged, so all three, a lot across the board to drive the agenda here.

Stephen Dover: Steve, let's turn to you on the small-cap managers and maybe even a subset of that, the small-cap companies, how are they able to deal with what's really pretty big changes that are happening in our economy, regulation, everything else around ESG?

Steve Lipper: Like I guess probably almost everything in small cap, it has its unique challenges and opportunities. Even the staffing issues on responding and calculating and supplying the data, you know, for small-cap companies in the smaller end of small caps, they're challenged in that. But the opportunity that we have is actually being a larger shareholder for a number of these companies, it's around the engagement. So, you know, Royce's approach on ESG is integration and engagement. I think it's constructively viewed as a parallel series of fundamental analysis, a series of factors and a series of parameters to engage, try to uncover mispricing, which is the essence of active management. And then engagement, as Sam was citing,  we're hired  by our clients to safeguard their assets and to do best by them. And we've got examples where we engaged with management, where they, you know, did not have the governance and not have a diversity policy, did not have compensation that we think was appropriate. We thought it was a good business model, but those things were of concern. We engaged with management and were unsuccessful at getting a change. And that was an investment that we sold. It was a food retailer. Another example was a paper manufacturer, almost similar, some issues around pension, about labor practice around shareholder rights. And we engaged with them actively and they did make changes. They made meaningful changes in a number of areas. So ,the smaller cap, it is a challenge. The disclosure is lower, but if you have the opportunity, the engagement and the impact you can make can actually be greater.

Stephen Dover: One of the questions all of us are asked is with equity markets at all-time highs, are there opportunities out there?

And certainly, listening to this, it makes clear that our economy is changing and we can actively look for a lot of opportunities out there. In fact, we need to be engaged with the companies, and that's particularly true for those of us who look at ESG investing. Steve Lipper, Sam Peters and Matt Moberg, thank you very much for joining us.

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