There’s no denying that, in the nine years since the end of the worldwide financial crisis, growth stocks and funds have been on an upward tear, to a large extent at the expense of those classified as value. But everyone living in the reality-based world knows that markets tend to be cyclical and that everything — both good and bad — has to end at some point. The question no one has been able to answer is when that moment will come.
To start with, let’s look at one of the major forces driving the market’s upward momentum. A large portion of the underperformance of value funds in recent years can be explained by the outperformance of the FANG (Facebook, Amazon, Netflix and Google) group and other index-boosting, “FANG-like” stocks. Most of these high-flyers have some combination of: a good story, high sales growth rates, minimal profits under generally accepted accounting principles (GAAP), triple-digit GAAP price-to-earnings ratios, highly levered balance sheets, and levitating stock prices.
Technology has changed everything, but perhaps investors are bit overconfident in terms of the long-term growth prospects and concurrent returns offered by some of these new business concepts. To illustrate the point it may be helpful to take a closer look at a couple of examples of “new economy vs. old economy” companies.
Let’s start by looking at retailing. Amazon has certainly revolutionized the shopping experience for American consumers, but while brick-and-mortar stores have faced massive challenges, they’re not going away anytime soon.
In March, Amazon became the second-most valuable company in the world when its market cap hit $768 billion. Yet between its founding in 1994 and the end of 2016, its cumulative GAAP profits were only $5.1 billion.
By comparison, Walmart’s cumulative GAAP profits during the same time period were $223 billion, or more than 43 times higher. Yet Amazon’s market cap was twice that of Walmart’s. Fast forward to today, and Amazon’s market cap ($778 billion) is now about 3 times Walmart’s ($245 billion), and in the past 12 months, Amazon’s stock price is up 70% compared with an 8.5% rise for Walmart. Amazon’s trailing P/E is 253x, Walmart’s trailing P/E is 26x.
Here’s another salient example from the entertainment field: Netflix (NFLX) vs. Disney (DIS). This table shows the GAAP profits for each company since Netflix’s initial public offering in 2002.
In 16 years, Netflix has earned cumulative GAAP net income of about $2 billion, while Disney earned $78 billion. (Netflix has never produced positive cash flow). And yet as of today, both companies have similar market caps (NFLX $142 billion and DIS $150 billion), with Netflix at 268x trailing earnings, and Disney at only 16.7x. In the past two years, Netflix’s stock price is up over 250%, while Disney’s is up 1%.
With a 95-year operating history, the Mouse House owns ABC, ESPN, movie studios, a vast and valuable content/character library, Pixar, Star Wars, Marvel, the Disney Channel and radio networks, theme parks, hotels and vacation clubs worldwide, cruise ships, a music business, a publishing business, a mobile/video game business, and retail stores, plus a brand name recognizable by most 3-year-olds all over the world. On the other hand, what does Netflix own? A cash-burning TV/movie studio business and a website. If you had $150 billion to invest, which business would you rather buy?
The upward trajectory of many growth-oriented ETFs and mutual funds has a lot to do with the index mania associated with passive investing and little to do with what those companies are actually worth. Passive growth funds tied to particular indexes have been outperforming value funds for the past nine years, and it’s created a self-sustaining cycle. Passive vehicles have been outperforming, so investors have been shifting assets from actively managed value funds. As their outperformance attracts inflows into passive funds, their managers buy even more of these mega-cap FANG and FANG-like stocks, which in turn drives their prices up even higher.
Most experts agree that this cycle has to end at some point, but no one can say for sure when that will be. And investors who are unprepared for that shift, which may or may not have a catalyst, are going to be in for a rude awakening.
Think of passive investing like flying a plane on autopilot. Autopilot works great when the skies are clear and the weather’s perfect with nothing to disrupt the flight path. We’ve seen that in passive investing over the last few years. It’s a great strategy that’s produced great results, but then again, the weather’s been pretty good. The problem with passive investing and with autopilot is when there’s some turbulence. When that happens you want an experienced pilot flying the plane.
When there’s a hiccup in the market or bad weather on the horizon, a seasoned and experienced active fund manager can actually do something about it. And over the last few months there’s been some turbulence, starting with the severe market drop in late January and the multiple ups and downs since then.
So, if the question is, when will value funds start to outperform again? A reasonable answer is, when investors collectively get over the mania of “FANG-like” stocks, and again focus on fundamental security analysis.
Timothy S. Schwartz, CFA, is executive vice president of Schwartz Investment Counsel and lead portfolio manager of the Ave Maria Value Fund (AVEMX) — part of Ave Maria Mutual Funds, the largest family of Catholic mutual funds in the U.S. with over $2.1 billion in assets under management.