Most of us look back on the tech bubble of 2000 with some measure of bafflement. What were we thinking? Were the rules of business success turned upside-down? Were tech start-ups, with marginal losses on every additional dollar of sales, going to make up their losses with volume? Could dozens of competitors, with no profits contemplated in their business plans, all hit their lofty sales targets – in parallel, with no price competition – and then deliver value to the shareholders by selling the company?
Will we look back on early 2009 with similar bafflement? Today, much of the deep value end of the market is priced for bankruptcy, even after the impressive recovery of recent weeks. Banks, consumer durables, industrials, even utilities, are priced at historic lows. For some industries, valuation multiples relative to book values, dividends, earnings, and especially relative to sales are even lower than they were in the Great Depression.
At the peak of the tech bubble, on average across our four valuation multiples, the “Fama-French” growth stocks, named after the economists who developed the measurement – the top 30 per cent, based on price/book ratios – were priced at more than three times multiples of the average company. Note that the 30 per cent assigned to growth are not the extreme outliers; these are mainstream growth companies. Historically, this ratio is typically about a 100 per cent premium; a three-fold premium for growth stocks was never seen before or since.
Most investors do not yet realise that today’s spread between growth and value, on most measures, is nearly as wide as it was at the peak of the tech bubble. But this time it is the value stocks that are the extreme outliers. For the value stocks (the bottom 30 per cent, based on price/book ratios), all four valuation multiples are near or below Great Depression levels. For one of the valuation measures, the price/sales ratio, the spread between growth and value is wider than ever.
Could this be an anti-bubble? Consider this: each bankruptcy leaves the survivors with less competition, more pricing power and more profit potential in the next cycle. Do the prices of the deep value stocks reflect their risks of failure? Of course. Are the deep value stocks priced to reflect the potential rewards for the survivors? Probably not. Will all of the deep value stocks fail? Of course not.
The sceptic would suggest that the economic outlook is bleak enough to justify these deep discounts for the value stocks, that deep value stocks are priced at unprecedented discounts to growth stocks because most face a higher risk of bankruptcy than ever before. Reciprocally, the growth stocks have resilient profit margins and rich cash reserves to cushion them in these difficult times. In short, the sceptic would suggest that the exceptional spread in valuation multiples between growth stocks and value stocks is justified by exceptional circumstances.
What does history suggest? We have an article planned for publication this summer in the Journal of Portfolio Management that examines this question: when the dispersion of valuation multiples is unusually wide, does it predict a wide dispersion in future growth, or does it predict the relative performance of growth and value stocks? In an efficient market, today’s wide dispersion should mean that growth stocks will outgrow value stocks by a wider margin than normal, so the dispersion is fully justified. The historical evidence does not support this view.
Over the past 50 years, when the average growth stock was priced at less than a 60 per cent premium to the average stock, growth beat value nearly two-thirds of the time. When the average growth stock was priced at more than 120 per cent premium, growth beat value only twice (1989 and 1999). Today, that spread is 140 per cent. This could be a problem for growth stocks, and a boon for the battered value stocks.
None of us can know whether the 2007-09 bear market has run its course. There remain ample grounds for concern. Deleveraging has barely begun. Home foreclosures threaten to dump immense additional supply on an overburdened real-estate market. Consumer spending and business investment relative to GDP are plumbing depths not seen in nearly 80 years. People spend when (1) they have money to spend and (2) they have confidence that they can earn – and keep – money to replace what they spend today. While much cash is still available, confidence is profoundly lacking.
It seems likely that, if the bear market is over, the leadership in the recovery is likely to be the much-loathed deep value stocks. If it is not over, it’s hard to imagine that technology can dodge the depression bullet, or that healthcare can maintain lofty profit margins in the face of a political environment that is poised to nationalise healthcare.
Rob Arnott is chairman of Research Affiliates
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