One of the first memos that Howard Marks, the co-founder and co-chairman of Oaktree Capital Management, penned to investors centered on the extremes of investment markets. He wrote:
“The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum ‘on average,’ it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.”
Though that narrative is 30 years old, it is no less applicable today. Take this week’s Chart of the Week, for example, which compares price-to-earnings ratios (P/E) for growth and value stocks over time.
Simply stated, value investors tend to buy stocks on the assumption that the present value is high relative to the current price. On the other hand, growth investors gravitate to stocks that they believe will grow value fast enough in the future to produce generous appreciation.
Generally speaking, the higher growth prospects lead to these companies receiving higher earnings multiples than their value counterparts. The same can be said for price-to-sales ratios (P/S), which measure how much an investor is willing to pay for a dollar of revenue. Growth stock P/S tends to be higher than value stock P/S.
Over the past 15 years, both the mean and median premiums (growth P/E divided by value P/E) are about 40%. The current growth premium to value is roughly double that at 80%. Currently, over 60 components of the S&P 500 Index trade in excess of 10x sales. This is the highest number of components trading above 10x revenue valuations in at least 40 years.
It makes some logical sense, though. Growth has outperformed value over the three-, five- and 10-year time periods. The “at home” stocks performed well during the pandemic and many of them are classified as growth companies.
However, as the global economy reopens, many value stocks — including consumer discretionary and energy sectors, to name just a couple — should begin to benefit from recovering demand. To that point, year-to-date value performance leads growth. Has the pendulum begun to swing back the other way? I think it’s too soon to know for sure but the pieces are certainly there to give it a push.
Pendulum swings from extremes are a common (and dependable) occurrence in investment markets. Investor psychology can change quickly. As a value investor, my investment process does not change over an economic cycle. I seek to identify opportunities that appear underappreciated and undervalued, and then practice patience, which is key.
Sometimes with value investing, being correct about something doesn’t necessarily mean being correct right away. As such, my focus will continue to be on dividend-paying equities that I believe have reasonable paths to a combination of sales growth, margin improvement and earnings-multiple expansion, with a potential bonus if the growth-to-value pendulum swing reverses in my favor.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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