Don’t Chase Returns
By Bradley J. Rathe
Chief Investment Officer
August 5, 2020
In the midst of the greatest financial uncertainty in over a decade, the NASDAQ 100, an index of the 100 largest non-financial companies listed on the NASDAQ stock exchange, is up over 19% year-to-date (as of 7-22-20). Microsoft, Apple, Amazon, Facebook, and Google are the five biggest companies in the NASDAQ 100 and make up over 38% of the exposure of the NASDAQ 100 index.
Many firms that are included in the NASDAQ 100 have put together proven track records of above-average growth and returns, especially in recent years. Another added bonus is that many technology firms are less impacted by the coronavirus, if not even helped by it, as consumers spend more time online instead of going places. These are a couple of the reasons some investors may see these as safe investments. However, in reality, these investments are not as safe as you might think, in part because of those above-average returns seen recently.
Benjamin Graham was one of the most famous investors of the 20th century. He was Warren Buffett’s mentor and the author of some of the most highly regarded texts in investing. In his 1949 book, The Intelligent Investor, he summed up why stocks like Amazon, Apple, Facebook, etc. may not be safe buys at the moment.
“The first is that common stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in their judgement and still not fare particularly well, merely because they have paid in full (and perhaps overpaid) for the expected prosperity. The second is that their judgement as to the future may prove to be wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement more difficult. At some point, the growth curve flattens out, and in many cases, it turns downward.
Growth stocks illustrate our thesis that the main characteristic of the stock market since 1949 has been the injection of a highly speculative element into the shares of companies which have scored the most brilliant successes, and which themselves would be entitled to a high investment rating. The investment caliber of a COMPANY may not change over a long span of the years, but the risk characteristics of the STOCK, will depend on what happens to it in the stock market. The more enthusiastic the public grows about it, and the faster its advance as compared with the actual growth in its earnings, the riskier a proposition it becomes.” - Ben Graham
Ben Graham is saying that a company whose stock price has seen great price appreciation relative to earnings in recent times is a riskier investment, all else being equal, solely because the price has gone up and you are at a greater risk of paying in full or overpaying for your stake in the company, which likely leads to lower future returns. Buying a stock just because the price has gone up recently is quite possibly the worst reason to purchase a stock.
We are always on the lookout for what is cheap and what is expensive. We want to buy cheap and sell expensive. The market hates uncertainty, and these are uncertain times, where future growth may be stunted in many industries due to the coronavirus, higher future taxes to pay for stimulus, etc. Investors are willing to pay a premium for companies that have still have above-average future earnings potential and are less impacted by the coronavirus, which provides investors more certainty. This is part of the reason we’ve seen growth stock prices rise. We don’t see this lasting forever. As shown in the graph below, growth has outperformed value by over 25% year-to-date. We believe growth has become expensive, and value has become cheap.
Value vs. Growth Total Return Year-to-Date
We see similar dispersion in US stocks compared to international stocks. The S&P 500 has outpaced the Developed World ex-US BMI Index by nearly 9% year-to-date and by over 53% over the past 5 years. Relative to US equities, we are neutral with respect to developed international countries’ equities. We had been favoring US equities over international equities for the past few years. In order for us to favor international equities over US equities, (1) we will need to see even more fiscal and monetary stimulus flowing into the European economy, (2) a weaker US Dollar and (3) European interest rates, if not positive, at least closer to zero.
S&P 500 vs. Developed World ex-USA Total Return Year-to-Date
A new bull market very rarely repeats the one that preceded it. The sector that led the way in the previous bull market has almost never lead the way in the next bull market. For example, in the late 1970s, energy was the leading sector, and in the next bull market, energy was the 8th best performing sector out of 10. Technology was the worst-performing sector of the late 1987 to July 1990 bull market, but was the best performing sector of the following bull market that took place for most of the 1990s. Financial services was the top-performing sector of the 2002-2007 bull market but was one of the most average sectors of the bull market that began in March 2009 and ended this year. If history repeats itself, technology will not be the best performing sector of the next bull market.
Growth Stock – Companies with positive cash flow that are expected to increase earnings at a faster pace than its industry average. These could outperform the overall market because of their future potential.
Value Stock – Companies with a stock price trading below their true value based on fundamentals like earnings and dividends, amongst many others. These could outperform the overall market because the investor is buying at a “discount.”
Unless otherwise expressly indicated, the opinions or views expressed in this article are the author's own and do not reflect, and may differ from, the opinions or views of StrategIQ Financial Group, LLC or others within StrategIQ Financial Group, LLC, including its officers, managers, owners, employees or other service providers.