Nerdy investment professionals often talk about ‘factors’ when investing. Factors are general characteristics of stocks that can appear more or less attractive depending on your view of the world. Two factors which have polarised debate since 2009 are ‘value’ and ‘growth’. 
Most investors have a tendency to believe ‘value’ is good. The argument is complex, but essentially leans on a belief in mean reversion and intrinsic value. Both concepts, in our view, are intellectually comforting, but quite possibly flawed. Many investors also like ‘growth’, but frequently worry it can get ‘too expensive’. The outcomes from preferring, for whatever reason, one factor over another in the last five years have been wildly different.
There are many theories as to why this has been the case, but perhaps the most credible one is based on ‘disrupters’ and ‘disrupted’. To simplify and summarise: sometimes ‘growth’ stocks steal growth from other companies through disrupting – essentially winning by others losing. In a sort of zero-sum game, this creates pools of stocks, or disrupters, which grow faster for longer, by causing trauma for another pool of stocks, the disrupted, which slowly die.
We have noticed it has become unusually easy to characterise a lot of growth stocks as disrupters and an unusually large number of value stocks as disrupted. The trouble with the disrupted the fact these stocks are unlikely to mean revert. All this may make perfect sense, but we have the added complexity of perceptions to deal with.
Two types of stocks have done especially well so far this year – disruptive growth stocks, and safe defensive stocks. One type of stock has done especially badly – disrupted value. However, last quarter this clear delineation of winners and losers, from a stock market sense, got a lot more volatile. In particular, both disruptors and disrupted stocks experienced a much bumpier ride. The spread in performance between growth and value has been cumulatively wide since 2011, but the divergence has accelerated at an unusual pace this year.
Perceptions over the relative merits of both types of stocks have shifted sharply. We believe stock markets can become over-confident about the speed at which slower structural trends move. In a day-to-day environment where speed and immediacy feel like everything, it is easy to forget how long things usually take to fully unfold. Stock prices move fast and sometimes perceptions can get ahead of reality. We think this is what happened last quarter.
We have not discovered an objective and easy way of gauging when the views of others get extremely overexcited or gloomy about particular themes. However, having lived through the flash crash of 1987, the double-dip recession of the early 1990s, the LTCM blow-up of 1998, the TMT boom and bust and the global financial crisis, we think we can tentatively recognise some of the signs of possible extreme perception shifts.
One of them could be an unusually wide divergence of performance between factors like growth and value, another may be an unusual pickup in the volatility of performance between such factors. Whatever the answer, we took the prompt from an unusually violent few days in September to conclude it was prudent to have a more agnostic view over the relative merits of value and growth.
Hence, we sold a number of strongly performing positions and bought a few stocks with more value characteristics. These are stocks we have been watching for some time and believe fit the other aspects of what we look for – in particular, sensible management behaviour within sensible robust businesses.
So, what next? We remain fairly sanguine about the overall prospects for stock markets. We do believe news will continue to have a negative slant and for many stocks facing structural pressure from being disrupted, life is likely to remain tough and probably get tougher.
On the other side, there are quite a few stocks we like from a management behaviour perspective that are exhibiting unusually easy growth – largely because these companies are disrupting other businesses. However, we do not actually own every stock at the moment – as we still fret about the faster moving waxing and waning of investor and analyst perceptions. Some general gloom might take more of the zeal out of the stock prices and present an opportunity to buy over the next year.
Jeremy Lang is partner and co-founder of Ardevora Asset Management. The views expressed above are his own and should not be taken as investment advice.