"I decided to close my fund and return capital to investors. ... Reporting sustained underperformance was making me miserable."
— Whitney Tilson, famed value fund manager, September
Last month this column briefly referenced that today's tech boom companies, in comparison with traditional "value plays," are more expensive than they were during the peak of the dot-com boom. This is a pretty bold claim and warrants further discussion.
Bank of America's investment management arm, Merrill Lynch, publishes a periodic review of U.S. growth stocks versus the universe of value stocks in the marketplace.
Growth stocks tend to be characterized by companies with strong revenue growth, even if profits are thin or nonexistent. In today's market, investors have bid these companies up to nosebleed levels.
Value stocks can be characterized by a number of factors, but often include companies trading at a large discount to the value of the assets in the business or low prices in relation to the cash profits of the business.
Historically, over long stretches of time, value strongly outperforms growth. But during brief measures of time, this may not be the case.
In the years leading up to the dot-com bust, growth stocks were loved and value stocks were thrown into the dust bin. After the collapse of the dot-com bubble in 2000, value stocks strongly outperformed up until the financial crisis in 2008, more than making up for their lagging period of the late 1990s.
Coming out of the recession, growth stocks took the reins and have helped power the markets to new heights over the last few years. A number of factors have contributed to this march higher.
The skewing of investor fund flows into passive indexes, where growth companies have large weightings, creates a feedback loop that drives the stock prices of those companies higher. The suppression of interest rates also gives companies like Tesla and Netflix — which earn little money, or even lose money each quarter — access to cheap capital. Finally, it just feels good to own what everyone loves.
Over the last nine years, value funds have had periods of strong outperformance, including late 2009, 2013 and 2016. These coincided with periods of dollar weakness, inflationary concerns and fears of higher interest rates — which typically favor value strategies and penalize high-flying stocks.
While many value funds had great a 2016, several have lagged in 2017 as momentum stocks have raced higher. Whitney Tilson's Kase Capital Management (featured in our quotation above) is not alone. In the last several months, other well-known hedge funds have closed including the $7 billion hedge fund Eton Park Capital Management, billionaire Richard Perry's hedge fund firm and the Hugh Hendry flagship fund.
"I died in active combat," Hendry told Bloomberg at the time. "The last three months were harrowing."
The key to remember is that the pendulum between value and momentum strategies often swings over stretches of time. After the strong performance of value funds in 2016, my business partner and I completed a study to see how value funds typically fared in the three- to four-year period after the pendulum swung back toward value. We found value strategies fare very well over the subsequent period, but the outperformance does not happen in a straight line.
Within that three- to four-year span, momentum may reign for a few quarters at a time. But the realities of financial gravity — the universal forces that pull high prices back to the ground again — eventually weigh down the high fliers. When that happens, the allure of owning bargains and those with real cash flows returns to prominence.
For value fund managers like Tilson, or investors who have entrusted their wealth to these managers, the question becomes: Can you withstand the inevitable pain that comes along with these fluctuations over time?
Those who cannot often wind up selling at the lows of the cycle. Those who can, or even dollar-cost average into the bargains during the span of the cycle, find they truly outperform in the long run.
Jonathon Fite is a managing partner of KMF Investments, a Texas-based hedge fund. He is an adjunct professor with the College of Business at the University of North Texas. This column is provided for general interest only and should not be construed as a solicitation or personal investment advice. Comments may be sent to email@KMFInvestments.com.