Why the great growth-value reversal will come with a whimper, not a bang

In recent articles, I’ve written about the increasing performance and valuation gap between growth and value stocks. Subsequently, I’ve had a few people ask how this gap will unwind. In one case, the person couldn’t envision it happening. After all, growth companies have unassailable franchises. They’re either dominating the competition or disrupting the industry. Future profits are all but assured.

I admit that, at times, a reversal of trend seems improbable, but I always come back to the fact that value stocks have beaten their shinier, sexier cousins over the long term. Indeed, there are a multitude of ways the gap can narrow.

Catching up to the valuation

Growth stocks trade at price-to-earnings multiples (P/E’s) well above value stocks. Some even attain ‘priced for perfection’ status — i.e. the price reflects a continuation of high profits, fast growth and unlimited potential. When the premium for growth goes too far, however, the company may need to grow into its share price.

Think about a case where management meets its growth targets, but the P/E retreats from an over-enthusiastic level to something more sustainable. As a result, the stock goes sideways (or down), sometimes over a number of years.

The most extreme examples of this occurred in the late 1990s. Cisco’s stock peaked in 2000, even though it continued to grow after the tech bubble burst. Its P/E went from over 100 to the low teens over the next ten years. Other stars from that period like Microsoft, Coke and Home Depot continued pumping out profits, but took a decade or more to reach new highs.

Conversely, value stocks never feel loved. There’s no momentum players or hot money to be found. Their valuations are built on low expectations, which leaves room for multiple expansion, or at least minimal contraction.

Running on fumes

Some growth companies slip into maturity without people noticing. They’ve gained all the market share they can, product line extensions are no longer working, and the easy cost cutting is done.

This phase can deliver a double whammy for shareholders. Profit forecasts come down, which in turns leads to a reduced valuation. It’s a bad combination — a lower multiple on lower earnings.

Value stocks, on the other hand, have already run out of gas. They’re on the other side of the valley working to reinvigorate their businesses.

It’s cyclical, stupid

When trends go on for a while, it’s easy to lose track of how much is coming from secular versus cyclical forces. The longer they stretch out, the more we hear words like ‘disruption’ and ‘paradigm shift’, but investors ignore economic cycles at their peril.

The rise of the Nifty 50 in the 1970s, Japanese stocks in the 1980s and U.S. real estate in the early 2000s were all based on secular trends that turned out to be cyclical. And the last commodity boom was billed as a ‘supercycle’ because of China’s unquenchable thirst for resources. You guessed it. Just another cycle.

Right now, Google, Facebook and other advertising-based businesses are vacuuming up promotional dollars. Clearly there’s a structural shift going on, but advertising tends to be cyclical and promotional budgets have limits. These ad machines have yet to go through a recession.

If a value stock is cyclical, there’s no mistaking it. But well run, cyclical companies will have their day in the sun, especially after dark periods of low capital investment and capacity reductions. As the adage goes, the solution to low prices is low prices (i.e. less investment, reduced inventories and fewer competitors).

Expectations never met

Some growth companies never achieve their lofty projections. The growth isn’t there and/or profitability is elusive. Today, tech darlings like Netflix, Snapchat, Dropbox and now Spotify are a long way from meaningful profitability, as are future public companies like Airbnb and Uber.

Then there are the already-profitable companies that simply go kaboom. Growth companies one day and restructuring stories the next. In Canada, Nortel, Blackberry, Valeant and Bombardier fit in this category.

It’s hard to say when value stocks will recapture their lost ground. They aren’t flashy, so there won’t be an announcement or parade. It often happens quietly. Value just starts going up more and down less than growth.

Tom Bradley is President of Steadyhand Investment Funds, a company that offers individual investors low-fee investment funds and clear-cut advice. He can be reached at tbradley@steadyhand.com