15 Oct 2021
The Mechanical, the destructive, the hopeful
One of the most popular charts today in investing circles is this one (see Exhibit 1):
Fama & French Portfolio Factors: Value vs. Growth (Exhibit 1: Value Outperformance of Growth Over Past 80 Years)
This chart clearly shows that value has outperformed growth 83% of the time over the past 80 years. Value managers often use this chart to make it clear that they believe value will outperform again—and imminently. In fact, as I write this, that time may be now. Value has outperformed the market tremendously for a portion of this year and value managers must be starting to get a little of that old feeling back. To be fair, it is a feeling they must be used to. Said another way, any portfolio manager over the age of 30—which I am guessing is the bulk of us—was likely taught, mentored and practiced in the art of value and mean reversion investing. After all, anything that outperforms 83% of the time for three quarters of a century is about as close to a “sure thing” as one can expect in any investing environment.
The important thing about data is to draw the right conclusions from it. You certainly wouldn’t want to exit the “dot com” bubble in the year 2000 and say “well, I should never invest in a single tech stock again.” That would be drawing the wrong conclusion from a data-driven event. So, let me share a few points from this Exhibit 1 from my perspective as a growth manager.
First, this chart has more than a few biases. The bottom of this chart is absolutely dropping off the page and into the reader’s lap, begging the question, “when will the insanity of it all end?” As an unapologetic growth portfolio manager, to me this chart is upside down—like one of those maps where Australia is on the top of the world and North America and Europe are on the bottom (see Exhibit 2). Neither are right, of course. It is simply a matter of perspective.
For illustrative purposes only.
Second, there is a bias of scale. A y-axis of +15% and -10% exaggerate one side over the other; we believe that y-axis symmetry is more appropriate. Simply put, we would reverse these two biases, and instead change the scaling and flip the chart so it looks like Exhibit 3. That chart looks slightly better, but doesn’t quite prove the points we are trying to make, so let’s continue.
FAMA & FRENCH PORTFOLIO FACTORS: GROWTH VS. VALUE (Exhibit 3: Growth Outperformance of Value Over Past 80 Years)
The chart has another bias that may be even harder to see because the idea behind it is so ingrained in the value investing psyche: it suggests a reversion to the mean . Mean reversion, a bedrock idea of value investing, is the theory that fundamentals can temporarily decouple from the economy but will eventually return to a stable equilibrium. Therefore, to be a successful mean reversion investor, one should invest when a stock is underperforming. This chart also implicitly suggests that we will go back to a time in which value outperforms sustainably.
A couple examples of mean reversion might help illustrate the point. If oil trades between a range of US$30–$70, a mean reversion investor might buy oil at US$30 and sell at US$70. After all, transportation isn’t going away. But what happens when electric vehicles start to make a meaningful dent in the global auto fleet? If there are three television networks in the United States, a mean reversion investor should buy the station with the worst ratings because they are bound to find a hit show. After all, there are only three networks, we must watch something. What happens when we start watching TV on our computers?
We believe in periods where there is a meaningful behavioral shift, mean reversion fails . It is our assertion that mean reversion works best in stable competitive environments. Mean reversion equates to being “short” or investing against innovation and change. It is, at its essence, a view that everything will revert to a stable equilibrium . That’s a tough investing stance if you believe, like we do, that we are on the precipice of one of the greatest periods of innovation we have seen in the past hundred years. We highly recommend you read our August 2020 piece, “Investing in Innovation,” to go deeper into our thinking on this seminal moment we find ourselves in as investors.
As investors in innovation in the public markets, we seek breakouts. Breakouts suggest something new or something different is happening, so let me amend the original chart one more time. As you can see in Exhibit 4, we shortened the timeline to the past 10 years—we’d argue that a 10-year time horizon is more relevant for most investors than an 85-year horizon.
The Breakout of Growth (Exhibit 4: Growth Outperformance of Value Over the Past 10 Years)
Now this chart, to us, is very interesting. It is a breakout. It implies that something may have happened in the economy since 2011 that is structural, new, different and should be accounted for in our investment analysis. And guess what? We do believe something happened.
In this paper, we will highlight three reasons we may be experiencing the demise of mean reversion investing and how we may be at the beginning of a period, perhaps as long as what has been experienced over the past eight decades, in which growth outperforms value. The first reason is mechanical, the second destructive and the third is hopeful.
We hope you enjoy the paper.
Matthew Moberg, CPA
Senior Vice President,
Portfolio Manager,
Franklin Equity Group
Key Takeaways:
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