The outperformance this year of a group of stocks with a price-to-earnings (P/E) ratio of 406x flies in the face of everything we know about long-term investing, suggesting the dominance of growth over value is unlikely to last. 
This is according to Lyrical Asset Management’s Andrew Wellington (pictured), who runs the global quality value mandate at Alliance Trust.
Wellington said that with the poor performance of value investing in recent years, many people are – rightfully – asking the question, ‘why would anyone want to invest with a value manager?’
In response, he carried out research in which he took the 1,000 largest stocks in the US market and sorted them into 10 equally-weighted buckets of 100 based on their P/E ratio at the start of the year. Over the past 20 years, he said the results are clear.
“You can see that historically the cheapest stocks do better than those that are more expensive,” the manager explained.
“And the very most expensive stocks do by far the worst. This is why you want to invest with a value manager.”
Source: Willis Towers Watson
However, to the end of September this year, the cheapest stocks are doing worse rather than better, with the only four buckets that have outperformed the S&P 500 in 2018 being the four most expensive.
Wellington said that what is even more striking is just how expensive these stocks are.
“The second bucket from the right has an average P/E of 35x – that’s 100 per cent higher than the average P/E of the S&P 500,” he added.
“And the one on the far right, admittedly there are negative earnings in there which can skew it, but that has an average P/E of 406x.
“So, this time it could be different, but that’s not the way I would bet.”
Source: Willis Towers Watson
Wellington is not the only manager predicting a value comeback. In a recent article on FE Trustnet, Schroders’ Simon Adler said that the human emotions responsible for every rally and correction in history aren’t going anywhere any time soon, suggesting the market will always revert back to a focus on fundamentals.
“We’re all just as greedy, just as fearful and just as emotional as we ever were and that’s what drives markets,” he said.
GQG Partners’ Rajiv Jain, who runs Alliance Trust’s global high-quality mandate, agrees with Wellington to a certain extent. He said this period could be similar to the one in 2000 where if you bought any non-tech names, “you would have done really well”.
However, he warned it is not as simple as saying that value looks poised to outperform, adding that there are two important details in particular that investors need to take into account at this stage.
“Number one, there is a lot of disruption happening in a lot of industries,” he said, “and a lot of value names which have done poorly have also been impacted by this disruption.
“So, I have been wondering how much of the underperformance is coming from disruption and how much is coming from the whole value cycle?
“Number two is that there has been a broad consensus that this is the tail-end of the cycle and cyclical names tend to get hurt more at the end of the cycle, because people expect the earnings to roll over.
“So, I think it is a little bit more nuanced in terms of which areas have been actually disrupted and which have sort of been de-rated because of the expectation of a cyclical downturn, not a fundamental downgrade.”
But what do the growth managers think? Sustainable Growth Advisers’ George Fraise, who runs the high-quality global growth mandate for Alliance Trust, is unconcerned about the prospects of a value/growth reversal.
Any argument that says you should buy the most expensive stocks and avoid the cheapest ones, or vice versa, is clearly flawed, according to the manager, as for him it is all about the underlying fundamentals.
“We are growth managers, make no mistake about it, but we pay a lot of attention to valuations,” he explained.
“One of my partners – Rob Rohn – has the dubious label of confusing institutional managers because he juxtaposes terms quite often and he keeps saying, ‘you can’t be a growth manager without being a value manager’, and a lot of institutional investors will say, ‘what the heck does that mean?’
“What he means is we pay a lot of attention to how much we pay for a particular company. You take a look at the fundamentals, you take a look at the growth algorithm, you take a look at the conviction you have in the sustainability, and the lack of variability in that growth algorithm. And then you have to make a decision on how much you want to pay for it at any point in time.”
He added that in the current environment where the market is driven by speculation and the fastest growth companies are awarded the highest valuations, regardless of quality, it is more important than ever to be selective.
“It’s not as easy as saying ‘value is dead’. Value isn’t dead, and it’s not as if growth is just going to roll over,” the manager said.
“I think certain components of the growth universe are clearly due for a significant setback, but there are businesses out there that you want to own for the long term, that I am absolutely sure about.”