I was pleasantly surprised last week, not just because I was reminded of the upcoming long weekend, but also because I saw the following headline in the Herald.
I was surprised as the article started off talking about value investing. The p/e ratio (price vs earnings) is one way investors distinguish between value stocks and growth stocks. For the sake of simplicity, value stocks are "cheap" stocks and growth stocks are "expensive".
The difference in performance between cheap value stocks and more pricey growth stocks is well documented. Eugene Fama and Ken French developed their 3-factor model back in the early 90s, proving value to be the most significant factor in estimating how a stock will perform relative to it's peers. Their model explained more than 90% of long-term performance with only 3 variables.
Yet these factors are seldom discussed in the media. It is refreshing to see this topic brought up, though not surprisingly, this follows a start to the year where value stocks have done far better than growth stocks.
How much better? Well we know the S&P 500 index, representing the 500 biggest companies in the states, is down about 15% for the year to date. Here is the performance of the S&P 500 Growth Index, which is focused on only growth stocks.
And here is the performance of the S&P 500 Value Index.
What a difference! It seems the largest value companies in the US have outperformed the largest growth companies by 17% since the start of the year!
And yet the performance of the S&P 500 is closer to the growth index than the value index. This is because the biggest companies tend to be quite expensive "blue-chip" companies. At the start of this year, the big tech stocks represented about 30% of the overall index. While these, and other growth stocks, have been performing poorly, the index has been dragged down with them.
I mentioned above that growth companies can be considered "expensive", and value stocks "cheap". One key metric used to judge value vs growth is the price-to-earnings ratio. Put simply, how much am I paying for a company's share compared to how much that company is bringing in?
All else aside, a higher p/e ratio means a more expensive stock. Fama and French's research showed these higher ratios are correlated with poorer performance and vice versa.
Consider the FAANG stocks; Facebook (now Meta), Apple, Amazon, Netflix and Google (now Alphabet). At the start of the year, these all qualified as growth stocks. An average stock in the S&P 500 has a p/e ratio of 16 currently. Here are the p/e ratios of the FAANG stocks at the end of 2021:
Facebook - 24
Apple - 29
Amazon - 66(!)
Netflix - 54
Google - 26
All of these companies were considerably more expensive than the average US stock. Netflix and Amazon shares were more than three times more expensive than the average when adjusting for earnings.
I mentioned growth stocks have led the overall market's charge downwards, and these FAANG stocks are certainly no exception. Facebook is down more than 40% year to date, with a new p/e of 16. Netflix is down a whopping 66%, with a new p/e of 18. Funnily enough, following these drops, the p/e ratios of these shares now looks a lot like the average market! Amazon is down 29%. Alphabet and Apple are nearing 20% down.
This disparity between two halves of the market puts this year's poor performance in a new light. The relatively cheaper stocks have fallen slightly over the past five months while the expensive growth stocks have dropped considerably. It is only reasonable to suggest this is simply a market-wide repricing of these stocks, whose prices have soared over the past few years.
Now, this is not to say they were over-priced at the start of the year. Markets are very efficient at pricing in information, including both the figures on balance sheets and more intangible risks. Investors are willing to pay high prices if they expect these companies to grow their earnings significantly in the future.
However, sometimes those intangible risks don't pay in your favour. Facebook announced this year they had lost users for the first time since their creation. Suddenly investors had to reevaluate the company's potential for earnings growth and so the share price fell.
More broadly speaking, central banks around the world have announced plans to hike interest rates to combat inflation. Coupled with supply chain issues and other rising costs, investors have reconsidered how much these expensive companies can increase earnings in a less rosy environment. Many companies have also announced lower earnings expectations this year. The drop in prices for the year to date reflects these developments.
The morale of the story - markets are working well to price in new information. The drop in prices we've seen so far is a normal reaction to this information.
Performance for the year to date is more due to sky-high expectations coming down to Earth than a collapse of markets. The stark difference between growth stocks and value stocks shows this.
Moving forward, we can't predict whether markets will go up or down, that depends on whether we get good news or bad news next. That isn't up to us to decide. As always, it's best to stay calm and focus on what we can control instead.