Disruption is a major theme in stock markets today with companies such as Amazon and Uber challenging the traditional approach to their respective industries. Such companies are an example of so-called “growth” stocks, with investors attracted by their prospects for expansion and future revenue growth.
Investors in “value” stocks, in contrast, focus less on a company’s future prospects and more on its current valuation and financial strength.
Critics of value investing argue that, since the technological innovation that is often associated with growth stocks is essential in today’s world, companies without it are unlikely to be the top performers in the future.
The stocks of companies that are changing the world, irrespective of their prospects of profitability, tend to outperform in times of optimism
Good companies vs good investments
It’s certainly true that older businesses are less likely to be the fast growers of the future. But this overlooks an absolutely crucial distinction between good companies and good investments.
For example, is UK supermarket chain Tesco being disrupted? It certainly is, due to the expansion of discount retailers such as Aldi and Lidl and the move to food shopping online. However, this didn’t stop the shares going from £1.40 in January 2016 to £2.60 in August 2018. Disruption may stop the shares getting back up to £5.00, but as long as you don’t expect that to happen, you won’t be disappointed.
The broader point in the frothy markets that we are experiencing today is that companies with better technology, higher potential future earnings and the ability to disrupt incumbents do not justify unbounded valuations. They can be very successful businesses while simultaneously being very dangerous investments.
The world is always changing, but that hasn’t stopped the value investment style outperforming for past 150 years. The chart below shows US stocks split by their starting price-to-earnings ratio, and their subsequent 10-year return. A lower P/E indicates a cheaper price. As we can see, the stocks with the lowest P/E (0-7) delivered the highest returns in the following ten-year period.
How can value investors benefit from innovative tech companies?
Value investors can and do benefit from new and innovative technology businesses, but only when they are offered to us at attractive prices. To say value investors cannot benefit from innovation is to view the world through a very short-term lens.
Just as a good business is very different to a good investment, a low price is very different from good value. If, however, you are patient, do your analysis and only buy into undervalued businesses with strong balance sheets, limited amounts of debt and a suitable ‘margin of safety’, then you will give yourself a good chance of outperformance, no matter what value investing’s detractors say.
The stocks of companies that are changing the world, irrespective of their prospects of profitability, tend to outperform in times of optimism as the market pays up for that potential.
Value stocks – businesses with tangible value today – are likely to hold up better in less ebullient times. This is because they are out of favour and therefore attractively valued, and these valuations are based on conservative scepticism rather than hope and faith.
The above article was previously published by Schroders on 18th September 2019