What are value stocks and growth stocks?
Firstly, let's quickly summarize what is a traditional value stock? It is a stock with a low price compared to last year's earning (Low PE Ratio) or a stock with a low price to book value. Their profits are often assumed to be similar to last year since these companies are more slow and steady moving.
Secondly, a growth stock can be viewed as a stock with a high price compared to last year's earnings (High PE Ratio) or a stock with a high price to book value. The higher price is associated with higher expected profits in the future.
Three reasons value investing may be dead
Growth vs. Value indices performance
Looking at the Wilshire Growth & Value indices we can quickly see how the growth stocks have massive outperformed value stock by more than 138%.
High P/E ratios
In combination with value stocks being outperformed the current average P/E ratio of 27 on the market means that people are willing to pay more than double the price of the profits of the companies. The high P/E ratio results in a lower amount of good value investing opportunities as well due to the historically high valuations.
Federal reserve driving the market
The quantitative easing scheme that the federal reserve has been doing aggressive monetary policy and printed trillions of dollars in 2020 to maintain the stock market and the economy from collapsing, since the stock market is based on supply & demand the result of the federal reserve printing trillions of dollars is that demand for stocks go through the roof and the S&P 500 is now at new all-time highs.
Has real value investing died out?
Although the three arguments above might prove that value investing is dead. Real value investing may not be dead at all.
Warren Buffets' definition of real value investing goes a bit different “an investment is worth to you only what it can deliver in future profits”. Therefore, instead of looking at past earnings, you should be estimating future earnings, so past P/E ratios should be ignored if you want to be a profitable value investor in 2020 and beyond.
Using a discounted cash flow calculator instead might be a more interesting solution to find good value investments since it is concerning future cash flows instead of past. The birth of the new business model of platform companies has made it possible to scale a company on completely new levels compared to traditional businesses 40-50 years ago.
The platforms companies are companies such as Google, AirBnB, Facebook & Uber. The cost for these companies to serve 50 million users compared to 200 million users are minuscule due to their business models. These companies might be viewed as growth companies, but following the principles of Warren Buffetts real value investing these companies can also be a value investment according to Warren Buffets key principles.
The core Warren Buffet principles will always be relevant over time since they just core investment principles. However, the economic landscape has changed in 2020 and it is changing the way investors should think about investing in the coming years.
The interest rates are near 0 % currently. This makes holding cash very unattractive due to opportunity costs. Opportunity costs describe the cost of holding cash compared to investing in the stock market. Looking at the stock market alternative 10-year US government bonds the return rate on these are also near 0% currently. The safe alternative is therefore also associated with high opportunity costs compared to investing in the stock market. This drives investors to invest further in the stock market due to the higher opportunity costs of not entering a position.
This current economic environment has happened before and historically been bad for the stock market once the interest rate starts increasing again due to higher inflation, but it is hard to say how long time we will see these low-interest rates.
How should you invest in the current environment?
The high opportunity cost makes it very unattractive to be sitting on a pile of cash right now you should therefore have some exposure to the stock market, but also be ready to invest on the way down if the interest rates start going up.
Real value investing is still very much alive and possible even in this hectic investing environment, but it requires you to be looking out for future cash flows instead of looking at the past. The historically high price-earnings ratios are making it harder for value investors to find traditional value investments and require you to look for creative business models that show great potential future growth.
Value investing is not dead – value investing is changing. The beauty of the stock market is that nobody can predict the future or what is going to happen and therefore it requires investors to be adaptive. This can also be applied to traditional value investing theory, being adaptive in a chaotic investing environment is required if value investors want to survive and come out profitable on the other side. Following the low-interest rates, the opportunity costs have never been higher and this can be troubling for value investors sitting on the sidelines waiting for that great traditional value opportunity.