The prevailing narrative among pundits on Wall Street today is that value investing is dead… a thing of the past… a tool only old fools cling to.
On one hand, I can hardly blame them for making such statements. During the last decade, growth stocks have outperformed their value counterparts by a large margin.
On the other hand… could value investing really be gone for good?
When To Switch From Growth To Value For Best Returns
It is true that, during the recent bull run, growth has ruled. However, if you look at the data going back to the August 2000 market top, the picture reverses. The returns on value are nearly twice as big as those from growth.
During downturns, sentiment about the future sours and the economy slows. As growth stocks lower their earnings estimates, investors begin to sell.
Apple’s (Nasdaq: AAPL) recent plunge is a perfect example. A so-called FAANG member, Apple was considered the ultimate growth stock. But, as soon as the company lowered its earnings estimates in the face of the global slowdown, investors flocked out.
Value stocks, meantime, typically trade at lower valuations and are shunned by most investors because of their boring growth projections. However, when the future looks uncertain and the economy begins to slow, it is companies with steady cash flows that become the darlings of the investing community.
Walmart (NYSE: WMT) is an excellent example of a boring company with steady cash flows, and it has been a clear winner in the last two recessions. During both periods, the stock’s value increased while the broader market experienced double-digit losses. The big-box retailer’s stable business model allows it to thrive even when the economy is weak.
Cheap Credit Is The Rocket Fuel For Growth Stocks
Another reason why growth significantly outperformed value in the last bull run has to do with the availability of cheap credit.
After the financial crisis, central banks pumped massive amounts of liquidity into the system by way of quantitative easing (QE) and, more specifically, low interest rates.
To understand what low interest rates mean for growth stocks, you have to remember the financial fundamental of net present value (NPV).
Government bonds typically represent i, and, during the recent environment of low interest rates, the return on them was low.
Future earnings are worth more when discounted by a lower rate (i), which is why companies with strong earnings growth saw their values increase during the last decade.
In previous periods, interest rates were quick to recover, and value investing made more sense. This time, however, the Federal Reserve kept rates artificially low for too long, fueling the growth stock bonanza.
How To Profit From The “Big Shift”
With interest rates finally rising and global growth uncertain, the time has come for what I call the Big Shift.
Over the next couple of years, growth will go out of favor. It will be replaced by value.
Millions will be made by those who can recognize the Big Shift and move fast.
The old principles of value investing don’t work in our modern environment.
Price-to-book value has been the worst performing indicator of the last 15 years. Even price-to-earnings, price-to-forward earnings, and price-to-sales are inferior to the ultimate value metric.
Instead, you should focus on free cash flow. It is a far more objective measure, unlike earnings, which can be manipulated using discretionary accounting techniques.
If You Can Win At Monopoly, You Can Win At Investing
It’s like the game Monopoly kids played before we had Netflix and Xbox.
In Monopoly, players compete by acquiring and developing properties. The one who collects the most rent wins. Usually, that’s the person who gets to purchase Boardwalk, because that’s the property that provides the highest rent/cash flow.
When you bought Boardwalk, you didn’t buy it because of its price. No. You bought it because of the future cash flows you were expecting.
Now, apply the same approach to value investing, and you will see that the best metric to use when choosing what to buy is price-to-free cash flow.
Value Investing Is A Lonely Journey
If you’re an experienced value investor, then you know that it can take a toll on your nerves. It means holding to your contrary opinions and waiting out long periods of below-average returns while growth is in favor.
Keep the long-term big picture in mind and don’t be swayed by one bad market cycle.