Jason Hsu, PhDScroll down
It would be an understatement to say that 2020 has been disastrous for value. 2020 was widely projected to be the year value reclaimed its historical place ahead of growth. This was not an unreasonable expectation given value’s 10-year underperformance, which was capped off by an unprecedented drubbing in 2019. Value was due!
This reversal did not materialize.
Instead, 2020 was a continuation of 2019, replete with many respected quant managers delivering their worst underperformance. This underperformance occurred in developed markets and China alike.
Yet this similarity in outcome should not be taken for granted. Over the longer horizon, the Chinese value factor has behaved very differently from developed markets’ value factors. And even in this case, we can observe different dynamics at play driving market valuations that can perhaps offer some insight into how, and even when, the situation will play out.
Value has underperformed since the Global Financial Crisis (GFC). But prior to the GFC, value reliably outperformed. Figure 1 shows that from the mid-70s through mid-2009, the world value factor delivered outperformance when held over a full-market-cycle. And the three years of sharp underperformance of value during the Tech Bubble, while testing and forging the modern-day value investors, ultimately reverted to reaffirm the supremacy of value investing upon the bursting of the bubble.
The billion (trillion?) dollar question today is: Were the last 12 years an extended growth bubble and, if so, will it result in a breathtaking value rally? Or has a true paradigm shift occurred and “this time everything will be different”?
Historically, growth stocks were, as Barber and Odean famously coined, “Glitz and Glamour.” They were priced for unrealistic growth and thus would ultimately disappoint. However, with QE and declining discount rates, all else being equal, growth companies, with their projected profits in the distant future, become more valuable. The math is similar to long duration bonds producing higher returns when interest rates fall. More importantly, growth firms like Amazon, Apple, Google, Facebook, Netflix and many others have out-delivered relative to the original rosy expectations. One cannot, in good faith, label them as entirely “Glitz.”
Growth names have largely justified their initial lofty valuation multiples and then some. Whether the market rationally expected the spectacular growth and “priced it in” or whether the investment gods gifted tech investors with a series of positive shocks, for the 10 years spanning 2009-2018, value underperformance in the United States cannot simply be dismissed as a protracted tech bubble, driven by valuation expansion. Today, given business model disruption from technology, comparing brick-and-mortar firms with technology-enabled firms using simple valuation ratios would not lead to sensible assessment and allocation. Yet, it remains to be seen if we can fix this problem by band-aiding book-to-price ratio with intangibles. Suffice to say, growth firms grew spectacularly from 2009 to 2018; as such it was also a period where valuation ratios forecasted future growth potential rather than expressed retail silliness.
Remember what I said above about value and growth cycles in China often not following those of the developed markets? Well, that was exactly the case from 2009-2018 where the value factor in China outperformed growth. This marks the great divergence between US growth and Chinese growth. Most of China’s high flying growth names have belonged to short-term speculative themes. These themes generally fizzle out quickly following the successful seeding of billions into new thematic investment products. Many Chinese growth firms have been textbook glitz and glamour and have faded quickly. And, it is exactly this “fading quickly,” which has produced the steady value premium observed in China. But in early 2019 things began to shift and in the past 2 years, that sustained growth rally has resulted in the average Chinese retail investors outperforming the professional investors.
This brings us to the last two years where growth names have wiped the floor with value names in both the United States and China. One could certainly point to the CV-19 work-from-home economy as the return driver for the likes of Amazon, Netflix and Zoom. One must also acknowledge that rational markets with rational pricing would struggle to explain stocks like Hertz and Nikola. Hertz, a bankrupt rental car company, was so actively bought by retail speculators on Robinhood that the company decided to issue a billion dollars in new shares. They clearly stated in the offering document that the $20B in outstanding debt will consume the equity capital immediately. Ultimately, the SEC had to step in to stop the madness. Nikola, trading at 290,000x to sales, is a firm which has re-discovered gravity as the ultimate clean energy for propelling their trucks downhill. However, Nikola currently relies on diesel burning tow trucks from other manufacturers to get their trucks uphill. The firm’s only reportable revenue so far seemed to come from installing solar panels at the chairman’s house. As we sit in endless Zoom conference calls with our colleagues, the US retail trading has quietly exploded from sub-5% historically to nearly 25%. And, David Portnoy of Barstool Sporting betting has been crowned the new investment god, replacing the Oracle of Omaha.
So, what about China? The China growth rally has seen value underperform by 30%. For 2020, growth themes in China ran a consummate sprint relay. First came the 5G themes, as Huawei stood defiant to Trump, backed by nationalistic consumerism. Then came the semi-conductor theme, as Chinese government poured unlimited subsidies toward the semi-conductor industry in response to the US microprocessor sanction. Then it was the biotech theme driven by the CV-19 vaccine development. Then it was the EV theme, where NIO rose as China’s Tesla and spurred a movement where literally everyone—from mall operators, to appliance retailers, to real estate developers—are now producing EVs. Most surprisingly, the travel and restaurant sector has become the best performing industry for 2020. This is singularly driven by a minor policy subsidy allowing duty free shopping (without international travel) in certain hard hit tourist areas. Today, this sector trades at 150x trailing earnings while delivering a 50% return relative to its “pre-Covid” price level!
Historically, the Chinese equity market has been roughly 85% retail by trading volume. 2020 felt like it went over 100% (see Figure 3). 27M new retail investors entered the Chinese stock market in 2020, adding more than $1T in new fuel to an already euphoric stock market. Note that the aggregate market cap for China A is $10T where roughly 65% would be considered free float. On top of that, an additional $1T in stock brokerage margin loans has entered the fray. The impact of this irrational retail trading can be demonstrated by seafood firm Zoneco. This firm gained notoriety and well-earned ridicule for its sudden and extreme financial losses caused by its farmed scallops “running away” as if led by Moses in an exodus. Despite its losses, no evidence of a turnaround, and an on-going investigation into their financial reporting and business practices, the stock rallied 150% this year after engaging heavily in a marketing campaign that included numerous celebrity spokespeople. The stock remains one of more richly priced story stocks in the market. While such stories are amusing, they also demonstrate what could happen when retail trading drive prices. Importantly, it also illustrates that this could get much bigger and last much longer before bursting. This, of course, is the mechanism for the short-term value underperformance and the eventual value outperformance in China—temporary euphoria driven by retail investor bias must converge back to true fundamentals.
Looking forward, what might be in store for the China value factor, and dare we speculate, for global value stocks? The question would be impossible to answer without arguing that the last two years are a bubble. Bubbles, while they might outlast your conviction, by definition, must burst. This reversion would not be guaranteed, if for the last two years, we were merely witnessing technology stocks outperforming their growth expectation. To examine the potential magnitude in value mean-reversion for China, we look back to the last bubble in China A-shares, which peaked in early Summer 2015. The 60% trailing 12-month value outperformance illustrates what can happen in China when retail greed gives way to fear.
In Figure 4, we depict value underperformance through November 2020. The two gray bars from 2015-2016 tell a credible narrative of a retail-driven market, whose periodic mispricing eventually reverse to the benefit of rational, fundamentally oriented, long-term investors.
Finally, let’s examine if the CV-19 vaccine might already be catalyzing a rotation from growth to the value. We have certainly seen US brick-and-mortar retailers like Macy’s and Nordstrom bounce back remarkably in the last month, along with banks (heavy lenders to the real economy) and energy stocks. On the other hand, tech continues to rally, as well, with the NYSE FANG+ Index—tracking companies like Facebook, Amazon, Apple, Netflix, and Alphabet’s Google—returning a market-beating +9.6% since the mid-November announcement of success in Pfizer/BioNTech and Moderna vaccine trials. This suggests that while rational capital has re-priced the “traditional economy” given the vaccine developments and deployment, a true style rotation will likely require the other shoe to fall. It isn’t enough for value stocks to recover from the impact of CV-19, glamour growth names will need to revert to more sensible prices.
Looking back to the “original” Tech Bubble as our last good comparable for today’s frothy environment in the United States, we find that from September 1998 through February 2000, growth stocks rallied by nearly +65% vs. value stocks’ +30% gains. While the bursting of the bubble came largely in the form of growth underperformance, with growth stocks collapsing by –40% through August 2001, value stocks largely remained flat over the same period. The real economy, proxied by the value stocks, was non-eventful, slowing relative to previous years but were not the driver of the collapse in tech stocks. The growth bubble came to an abrupt end as earnings disappointment piled up for the darling growth names. Extending the analogy, there isn’t a clear mechanism we can identify where the real economy’s recovery, which has driven the value stock rally, would simultaneously deflate the US growth bubble. It is likely that we will need to wait for growth firms to disappoint their now untenable growth expectation. As analysts begin revising expectations downward, and retail investors begin to sour on the glitzy stories and themes—at such point, the other shoe will fall. In the meantime, buying inexpensive and high-quality businesses overlooked by the retail masses whether in China or in the United States seems like a sound approach to position for the eventual shift in value’s fortunes.
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