It is common practice in the investment world to divide the market into two camps of stocks, “Value” or “Growth;” yet these principles are not opposites and a stock can be overvalued while experiencing slow growth, or undervalued while growing quickly.
Analysing the Russell 1000 Growth and Value indices over the almost 39-year life of the indices (from inception on 12/31/78 to 9/30/17), the Russell 1000 Value index had an annualised total return of 12.3%, while the Russell 1000 Growth index returned 11.3% per year. On the surface – it looks like Value is aptly named. But when we take a closer look all is not as it seems.
The truth is that while Value has outperformed on a cumulative basis, it can all be attributed to the short burst of strong outperformance in the early 2000s, as the tech and telecom bubble came undone. Outside of that period, there have been long stretches (such as the last ten years, or the 12-year period from 1988 to 1999) where the Value index underperformed, sometimes by wide margins.
If “Value” was capturing some sort of systematic undervaluation in the stocks that make it into the Value index, we would expect to see Value come out ahead much more often over short to intermediate periods. As it turns out, over rolling 5-year periods, Value has only outperformed Growth 52% of the time. The historical evidence does not suggest that the Value index, as constructed captures any kind of systematic undervaluation.
Yet there is a way to measure ‘Value’ that has a better record at identifying stocks that are likely to outperform, which is the ability of a company to generate free cash flow that makes it worth something to begin with.
How management allocates that free cash flow (between reinvestment in the business or distribution to shareholders) determines whether the company’s worth grows or shrinks. That philosophy tells us that a true measure of value should not be dependent on accounting based measured like earnings or book value. Accounting figures are too easily manipulated within GAAP rules, are distorted by accruals and ignore the time value of money. A better measure of value is one that relies on the free cash flow that a business throws off.
In our 2016 white paper, *“Free Cash Flow Works,” we demonstrated that companies with high free cash flow yields have outperformed the market by a wide margin over the years, while companies with low free cash flow yields have underperformed.
In contrast to both growth and value performance measures, free cash flow yield (the inverse of the price/FCF ratio) has been a much more reliable measure of “value”—defined as a price-sensitive characteristic that is likely to lead to outperformance—than the measures like price/book that are commonly used in widely followed Value indices.
Clients and consultants, hearing us describe our strategies as employing a “Value” approach, often compare our portfolios and our results to traditional Value indices, and are puzzled by what at times seems to be a mismatch.
Underlying that variance is the fact that Epoch defines value based on free cash flow characteristics, rather than on traditional accounting metrics. In the long run, we believe our way of defining value is both more meaningful and more likely to lead to good returns.
* This article is excerpted from our white paper, “What Do We Mean When We Talk About Value?” December, 2017.
Steven D. Bleiberg, MD, and Portfolio Manager, Epoch Investment Partners UK