Why the value style outperforms growth investing, and what are the attributes of successful value investors.
In this episode you’ll learn:
- What drives the long-term performance of stocks.
- What it takes for a stock to outperform the market.
- Why growth stocks underperform value stocks.
- What are the qualities of skilled value managers.
- What is risk.
Show Notes
The Oakmark Fund First Quarter 1999 Shareholder Letter by Robert Sanborn
Margin of Safety by Seth Klarman
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Summary Article
Why Growth Stocks Disappoint
1999 was an amazing year for the U.S. stock market. U.S. large company stocks as measured by the S&P 500 Index gained 25.2%, rising for the ninth consecutive year. In seven of those nine years the S&P 500 appreciated double digits, leading to an annualized return of 17.8% from 1991 through 1999.
The NASDAQ, a U.S. stock index with a large representation of Internet-related technology stocks, performed even better. It gained 86% in 1999. One out of six NASDAQ stocks appreciated over 100% that year while 44 gained over 1000%.
By year-end 1999, the top 100 names in the NASDAQ were selling for an astounding 136 times trailing 12-month earnings. Five years earlier in 1994, those same stocks were selling at a valuation of 23 times trailing 12-month earnings.
Investors justified investing at those lofty valuations because it was the “new economy.” The world was going to be transformed by the Internet and old brick-and-mortar companies would be eaten for lunch by hungry start-ups with .com in their names.
During this period, traditional value managers who sought to purchase stocks at a discount to the companies’ intrinsic value suffered terribly.
There were plenty of stocks that met those value managers’ investment criteria, but holding them meant they significantly underperformed the market averages. These managers were losing clients who considered them dinosaurs for not adjusting their investment process for the new Internet age.
A Beleaguered Value Manager
In March 2000, I flew to Chicago to meet with one of those beleaguered managers. His name was Robert Sanborn and he managed The Oakmark Fund, the flagship mutual fund for the investment firm Harris Associates.
Our institutional investment advisory firm had used Oakmark and Harris Associates as a value manager for our endowment, foundation and pension clients for years.
The main purpose of my meeting with Sanborn was to see how he was holding up amid the market bubble and to confirm he wasn’t going to change his investment process and style, despite disgruntled clients pulling millions of dollars from his fund.
The meeting was on a Friday and I left Harris Associates’ offices confident the firm would stick to their discipline.
In the meeting, Sanborn reiterated what he had written in early 1999 to The Oakmark Fund shareholders. “Unlike many mutual fund managers, we never ponder whether a stock is “going up.” Rather, we always populate our Fund with holdings that sell at the biggest discount to their true intrinsic value and have owner-oriented managements. Period. There are those that now say “Value is dead” or “The world has changed.” I disagree. In our experience, price and value always come together, and that dynamic allows The Oakmark Fund to add value. Sometimes, as now, this process takes longer than some would like. However, as an investor in the Fund and as one who totally believes in our investment philosophy, I will never abandon our approach. I know it works.”
The Monday after my meeting, Harris Associates notified us that they had fired Sanborn as portfolio manager for The Oakmark Fund and he was leaving the firm.
We were shocked. Apparently, the mutual fund board had lost confidence in Sanborn and the financial pressure of cash outflows from the fund was too great.
Ironically, after the move, Harris Associates experienced more outflows as we pulled hundreds of millions of dollars of our clients’ assets from the Oakmark Fund and from separate accounts that Harris Associates managed.
Why Certain Stocks Outperform
That same month our firm published a paper I had written titled “Should Fiduciaries Overweight Growth Stocks In Investment Portfolios?”
I worked on that paper for several months, spending hours in the library of my alma mater digging through academic journals, trying to understand whether the investment world had indeed changed.
I had only been an investment professional for five years, all during a raging bull market. Maybe it really was different this time.
From my research, I learned the long-term performance of stocks is driven by three building blocks: dividends, earnings growth and what investors are willing to pay for those earnings.
Every stock has an implied embedded growth rate priced into it. Investors are willing to pay a premium for stocks with higher expected earnings growth than for stocks who earnings are slower and more erratic.
But here is the key. A stock will only outperform the market if its actual earnings growth exceeds the earnings growth rate already priced into the stock.
Outperformance is not due to a company growing its earnings faster than other companies. All that matters is whether the company grows its earnings faster than what investors have assumed the earnings growth rate will be.
The Growth Style Wager
In my paper, I wrote, “Certainly the rise of the Internet and other New Economy technological advances has had a profound impact on capital markets and on our daily lives. Without a doubt, growth stocks deserve higher valuations than old economy value stocks since their earnings grow at a faster rate.”
“Nevertheless, fiduciaries that overweight growth stocks in their portfolios must understand that their wager is not whether technology related growth stocks will change the world as we know it. The answer to that is question is a definite yes.”
“Fiduciaries who overweight growth stocks are wagering that Wall Street analysts and other market participants are currently underestimating the earnings growth rates of these New Economy stocks, whereas historically they have overestimated earnings growth. If investors are willing to make the above bet, then the relevant question is…. does the potential benefit of being correct more than offset the penalty of being wrong?”
It turns out it wasn’t different that time. While the Internet continued to have a profound impact on our lives, investors significantly overestimated the earnings growth prospects of those same technology companies that were revolutionizing the economy.
The same pattern continues today with likes of Facebook, Twitter, Uber and the next technology darling that comes along.
In March 2000, the month Robert Sanborn was fired and the month I released my paper was also the top of dot-com bubble.
From 2000 to 2002, the NASDAQ fell 67%, obliterating the investment portfolios of many who truly thought it was different this time.
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