As we have written in the past, we believe that the value vs. growth construct is an arbitrary one that has no definitive meaning. However, we would be remiss if we didn’t acknowledge this stylistic dispersion and address it head on. Before we provide our views on this topic, it is important to understand how the market defines value and growth stocks. According to commonly used definitions, a value stock is one that has a lower-than-average valuation, as measured by various financial ratios, such as price-to-book or price-to-earnings (P/E), while a growth stock is expected to grow its per-share earnings, book value, revenues and cash flow at a higher rate than other businesses. In our opinion, all good investing is “value-oriented” investing. All businesses, whether fast- or slow-growing, cyclical or highly predictable, should be purchased at a discount to a conservatively calculated estimate of the business’s intrinsic value.1
Looking further into the dispersion between value and growth stocks, it is interesting to review the composition of the value and growth indices by sector. As shown in the table nearby, the value index includes a preponderance of businesses in energy, materials and financials, many of which are cyclical, that screen as value based on the metrics described. Unsurprisingly, the growth index has more technology, consumer discretionary and communication services businesses.
As noted, our portfolios own relatively little in energy and materials, and we are underweight financials, particularly banks – that is, the sectors that make up a substantial portion of the value index. Following on this observation, one might conclude that our portfolios are underweight “value” and overweight “growth.” Being intellectually curious, we have thought a lot about how our portfolios are positioned, and a few points are worth highlighting.
- All our managers seek to own businesses whose stocks are trading at substantial margins of safety.2 While our portfolios are underweight the cyclical businesses that traditionally fall into a “value” bucket based on the market’s narrow definition, we believe that we have a portfolio of “value-oriented” investments that can generate compelling long-term returns. We reject the notion of investing in stocks based on arbitrary backward-looking metrics, which do not give investors a true picture of a business’s future growth prospects and can be distorted by accounting conventions, such as not including intangibles in book value unless you acquire them.
- While all our managers focus on owning concentrated portfolios of competitively advantaged businesses that generate attractive returns on invested capital in excess of their cost of capital, operate in attractive industry structures and are run by long-term-oriented management teams that act like owners, each has a different approach to identifying such businesses. Some seek to invest in businesses that derive their value from their growth prospects, and others prefer to own more stalwart businesses with strong cash flow yields and steady growth. As a result, we believe our portfolios have ample diversification across businesses and economic drivers of value, and are therefore positioned to generate strong returns over time.
- We are comfortable not owning those businesses that are inconsistent with our strict investment criteria. Examples include many energy and materials companies, as well as some financials, where returns are dependent upon variables that are out of our control. While we recognize that investors can earn attractive returns by owning these businesses at the right time in a cycle, the timing of such is unpredictable, and we don’t consider that a repeatable way to generate compelling investment returns. Before the cycle turns, these stocks must be sold and taxes paid, thereby interrupting the compounding machine that is so important to growing wealth at above-average rates. We do, however, own some cyclical companies in distressed portfolios – when securities are trading at substantial discounts, and thus when returns are much less dependent on such factors as increases in commodity prices or interest rates.
2020 was an interesting year for fixed income markets. While 10-year Treasury rates had declined from a high of over 3% in 2018 to a range of 1.5% to 2.0% in the last half of 2019, there was still some yield available in risk-free fixed income at the start of 2020. As the COVID-19 pandemic took hold, however, the Federal Reserve again cut overnight interest rates to zero, and the 10-year Treasury quickly plunged to a new all-time low near 0.5% on March 9. While low rates were one effect the COVID-19 market disruption had on fixed income markets, March 2020 will also be remembered for unprecedented liquidity-driven selling that took place and the litany of Federal Reserve programs that were required to restore order to the markets.
Full-year 2020 returns do not do justice to the volatility that was witnessed during the year. Even CCC-rated high-yield bonds, which were down 22.7% in the first quarter of the year, recovered to post a 2.8% return for the year.3 High-yield credit spreads, which started the year at 3.4%, widened to 11% during March, before falling back to 3.6% by year-end as if nothing had happened. The Bloomberg Barclays U.S. Aggregate Index returned an impressive 7.5% for the year, a feat that it is unlikely to repeat in 2021 with a starting yield of 1.2%.
A recurring question from investors over the last decade has been what to do as a result of the zero interest rate environment. In contrast, for most of the 1990s and 2000s, 10-year Treasuries offered ample yield in the 4% to 8% range. As recently as November 1994, an investor could purchase a 10-year Treasury note at a 7.9% yield. In those days, investors could have yield, stability and liquidity just by owning risk-free obligations of the U.S. government. Now, you can earn a paltry yield of 4.2% in high-yield bonds, a volatile asset class where historically there have been annual credit losses in excess of 2%.
During times like these, it is important to go back to first principles and remember why we own fixed income in the first place. High-quality fixed income provides a source of portfolio stability in that, historically, it has been inversely correlated to equity markets. It is also a source of liquidity and can provide investors a small amount of yield. The fact that yields are lower than in the past does not negate fixed income’s role. Investors should regularly revisit their investment policy statement to determine that they have the right mix of equity and fixed income, but they should not stretch for yield in the part of their portfolio that is being counted on to provide stability and balance. Investors seeking yield should consider other strategies, including real estate and direct lending, but it is important to remember that these investments will likely not protect portfolios during a declining equity market.
Although we are fundamental bottom-up investors, it is our practice each year to develop capital market estimates for major asset classes. While we do not rely on these estimates for making investment decisions, we do utilize them to help frame expectations for returns and, in certain instances, to prioritize our research efforts during the year. Notably, these estimates are based on index returns and do not include estimates of manager alpha.
For 2021, our capital market estimates are in the below table.4