Halfway through the year 2021, we must be reminded to “not confuse brains with a bull market.” These are the words we were taught back in the 1980’s. When all boats float, don’t think you are a genius because your boat floated. Investors in the S&P 500 Index, mega-cap tech stocks, momentum disruption stocks and a wide variety of success stories the last five years floated. The former kings of the stock market (active stock pickers) were pronounced dead. Goodbye Warren Buffett, John Templeton, Peter Lynch and all the others who were declared kings of stock picking.
The death pronouncements were in money flows, on magazine covers and all over the media which covers Wall Street daily. Stock picking was officially dead, and no brand of stock picking was deader than value stock picking. Look at the chart below to get a ten-year feel for how growth trounced value and notice how the spread in results exploded the last four years:
This has left us with an S&P 500 Index which is the most tilted toward growth stocks since the dotcom bubble in 1999-2000 and the most concentrated in the largest of these companies ever.
One of the beautiful things about the laws of economics and statistical mean reversion is the pendulum that governs long-duration common stock performance. When growth stocks get on fire, we believe they almost guarantee poor forward results over the following ten years. Look at how this went from January 1, 1973 to August 9, 1982 and from March 9, 2000 to March 9, 2010:
When does stock picking work? It works best when the competition is the lowest and confidence in its usefulness doesn’t exist. Buffett and Munger say the key to investing success is “weak competition.” If investors take away the money from active stock pickers, and especially from value stock pickers, those who might compete with you to buy today’s bargains are diminished in numbers.
Second, the four main ways of generating alpha are enhanced by these circumstances. Stock selection becomes easier as value is starved of capital, negative sentiment improves future results, concentration is easier (because the opportunity cost gets eliminated) and long holding periods are more tolerable. This is because you don’t have to worry about money being made easily by all boats floating.
Confidence in Value
Why are we so confident that value stock picking will have an extended period of success? First, we believe the demographics of 90 million millennials forming households means that economic growth will almost certainly be much higher in the 2020s than in the 2010s. We like to explain that the anemic economic growth in the 2010s was simply a function of the Gen-X group being much smaller than the baby boomers.
Second, necessity spending crowds out spending on discretionary items. House and car payments, soccer shoes and insurance suck up disposable income. Out goes Seth Rogen movies, craft beer and Apple devices. Third, stronger economic growth puts interest rates on an upward path and price-to-earnings (P/E) ratios on a downward path. Growth stock investors thrive on an ever upward path of P/E ratio expansion.
Fourth, stock price success gets more closely tied to Main Street economics. Whoever is growing their earnings through economic activity and higher asset valuations ends up receiving capital, even as capital becomes more and more dear. Simultaneously, labor gets more expensive as Main Street outperforms both Wall Street and Sand Hill Road. As we wrote this, the head of the Teamsters Union was on CNBC making that case.
In all of this, someone must pick stocks well, rather than just participate to succeed as we go forward. To us, growth portfolios and expensive indexes like the S&P 500 look like they did in the charts in 1972 and 1999. It means they may offer an inordinately good chance for stock market failure. Thank you for your confidence and ongoing participation in our discipline.
© Smead Capital Management
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