2023-06-28 12:20:48 ET
Summary
- Growth and value stocks exist in different time frames, with growth focusing on the future and value on the present.
- The Magnificent Seven had accounted for all the market's gains so far in 2023, but only three meet all the criteria for growth.
- Amazon and Microsoft would be the best bets after a modest correction while Alphabet and Meta have a less certain future because of their inability so far to diversify.
Starting in January the stock market has been surprisingly strong. The term "market" is a bit of a misnomer, however, as just seven stocks - the "Magnificent Seven" - have accounted for 100% of the market gains as we approach mid year. The seven are, in order of market cap: Apple ( AAPL ), Microsoft ( MSFT ), Alphabet ( GOOG ) (GOOGL), Amazon ( AMZN ), Nvidia ( NVDA ), Meta Holdings ( META ), and Tesla ( TSLA ). There have been quite a few comments noting that leadership this narrow is highly unusual and generally not seen in a healthy market. Staunch bulls answer that a rising market is the only thing that counts, and add to that the current bull move is likely to see more stocks eventually joining in. Which side has it right? Your guess is as good as mine.
So far the year has belonged to the bulls, and there's no denying the fact that the Magnificent Seven are the main story. There have been periods in the past decade when a handful of stocks pulled the whole market up, reaching more than 30% of total U.S. market cap, but nothing in history has involved quite such a narrow focus as so far in 2023. To understand what has happened over the first half of 2023 one has to ask questions about the market leaders. Why growth? Why just seven stocks? Why now? The charter below provides a picture which it's possible to hang a narrative on, starting with the fact that mega-cap growth was neck and neck with the market as a whole through most of January and then steadily pulled away from the S&P 500 in February and March.
FactSet
At the beginning of 2023 the prevailing market narrative was predominantly negative. The yield curve was strongly inverted, one of the major predictors of a recession. Leading economic indicators had been negative for several months. Although inflation had been declining since its peak in June 2022 doubters pointed to the fact that much of the decline was in food and energy while wage inflation was being "stubbornly" persistent. Employment numbers remained strong and the unemployment number continued to gradually decline. These normally positive facts were taken as negative by many observers who preferred to emphasize the inflation problem. The often stated view of the Federal Reserve was that there's still a lot of work to do on the inflation problem. Thus Fed Chair Powell continued to make the threat of higher rates for longer.
A strong market when everybody is expecting hard times may seem a bit counterintuitive. The thing to remember is that the market tends to look out into the intermediate future. This was hard to do in the mix of somewhat contradictory possibilities at the beginning of the year but the bank crisis unfolding in early March led to a shift in the narrative. A persistent theme of Fed tightening is that it will continue until it "breaks something." It has become increasingly clear that the regional bank crisis was that breaking point. In order to keep up with the cost of deposits banks in general had extended fixed income maturities to increase yield and thus become vulnerable to a bank run as rates increased and long-term maturities dropped sharply in value. The Fed and the SEC acted furiously to halt the run. Three tech-oriented banks nevertheless failed and it became clear that further major hikes in rates came with major risks.
Stocks in general liked the increasing caution about raising rates but the big winners were stable growth stocks. The Magnificent Seven had the characteristics which would help them prosper in this environment, to wit:
- Quality as defined by low debt and strong free cash flow.
- The ability to maintain and increase revenues and earnings even if the economy was not particularly strong or even in recession.
- The fact that lower rates in the future (the likelihood being that the Fed would first pause and then lower rates) would decrease the rate for discounting future earnings. The value of all future earnings is a time series in which future earnings must be discounted by (1 + R)^N, R being the hurdle rate, N being the number of years. It was in part the prospect of a low hurdle rate which has made Growth companies attractive so far in 2023.
I discussed point #3 in more detail in this article. In short, following the crisis in regional banks, growth companies were able to look over the valley of high rates and recession to the environment in which Growth had prospered for a decade and a half. The Magnificent Seven seemed to check off all the important characteristics needed to prosper in this environment with the opportunities of Artificial Intelligence providing the icing on the cake.
The Invisible Advantage Growth Has Over Value
Value stocks go up once until they reach full valuation or perhaps overshoot it a bit. Growth stocks which continue to grow at a good clip can outrun excessive valuation. Over the years this asymmetry has been one of my primary tools for evaluating growth stocks. The current market P/E ratio is around 20. I'm using P/E here as a sort of shorthand for price to sales, cash, flow, and earnings; sales are really the best measure but are less commonly used by many investors. Real GDP growth is around 3% annually, to which you tack on another number, perhaps 3%, for inflation. That's more or less the limit on average growth of corporate earnings. What this implies is that under present market conditions any valuation significantly over a 20 P/E needs to be justified by higher growth. A typical stock with market-level growth and low to moderate risk should sell close to a 20 P/E under current market conditions.
Bearing this in mind, I have a personal formula for quickly estimating the value of growth stocks. A stock which has grown at a consistent average rate of 20% annually clearly falls into the category of growth stocks. Three years of past and estimated future earnings play an important role in defining both Growth and Value and Value as discussed in the next section of this article in the next section - no accident since three years of past earnings are readily available and three years of forward earnings are much easier to estimate than more distant numbers. For value calculations one just compares earnings to price. What 20% annual growth provides is a surprisingly powerful kicker. In the first year earnings increase by 20%. The compound increase is 44% in year two and reaches 72.8% by year three. It's easy to do the calculation in your head for various growth rates. A company which maintains 20% or higher annual growth is pretty sure to compound your money at a good clip. Even a gradual falling off of growth rate, a more or less inescapable fact in the long run, leaves a good rate of return. That's true even if current measures of valuation gradually decline, another inescapable tendency.
The further out you go the less certainty you can have of the future growth rate. The inevitable long-term decline in the growth rate is my primary motivation for reading quarterly reports and CEO/CFO transcripts. Quarterly comparisons are not in themselves important, but even a minor detail suggesting long-term decline in growth, however, should be considered carefully. Growth stocks are susceptible to that double whammy of slowing growth and falling P/E ratios.
If you have chosen a growth stock well, the rate of sales decline still allows enough growth to overpower the decline in valuation. Value stocks get no such help from compounding earnings growth. You buy Value stocks because they're cheap when measured against current sales, earnings, and cash flow. Your goal is for the market to recognize this and bump the price up substantially, but such an upgrade in valuation tends to be a one-time bump. The long-term destiny of most growth companies is a long slide in the direction of lower growth and a lower valuation. The length of time spent as a growth stock may vary, and in some cases may be extended by new opportunities or changes in business model. Growth, in other words, is part of a company's life-cycle and shouldn't be expected to last forever.
This pattern has been followed very closely and rather quickly in the case of Alphabet, a growth stock I bought a few years ago. In its early years Alphabet almost always reported earnings surprises to the upside, but its more recent sales and earnings growth has been strong but lumpy with a moderate decline steepening in the past couple of years. There's also a risk with Alphabet that a single bad event could undercut its future prospects. Antitrust action is the leading candidate for a bad "surprise." It's highly vulnerable to damage from such an event because of its failure so far to diversify away from its main business. There's a scrap of paper somewhere on my desk asking "Should I sell Alphabet today?"
How Recent Growth And Value Performance Illustrate The Growth Advantage
The chart below shows long-term relative performance of Vanguard Growth ETF ( VUG ) and Vanguard Value Index Fund ETF ( VTV ) with all companies in the two indexes deriving from the S&P 500 ETF ( VOO ). If you look closely at the chart you will see that growth has outperformed for a decade with the exception of a single year, Jan. 22 through Jan. 23. In 2022 overpriced growth stocks declined sharply and Value enjoyed a one-year catch-up moving from cheap relative to Growth to fairly valued. Before extrapolating too much from this pattern investors should note that Value leadership has at times lasted longer in earlier periods such as the early 2000s. Over the past decade growth has benefited from ideal conditions such as a burst of innovation and extremely low interest rates until 2022. Will these conditions eventually reassert themselves?
There are a number of reasons that growth stocks were the perfect choice for 2023 in particular. One was that the usual leaders in troubled economic times - healthcare, consumer staples, and utilities - already were fully priced and unlikely to do well if inflation proved to be the resolution of the Fed's conundrum. Another reason was that the mega-cap tech stocks had strong cash flow which enabled them to do fine without borrowing money from banks. The best argument, however, may be that if you don't pay attention to successful growth companies for a year or two you may be surprised to find that a couple of years of growth have outrun any correction in valuation.
How Growth And Value Reflect The Life-Cycle Of Successful Companies
The above sections focused on a tool I use to consider growth stocks and the way short-term economic and financial conditions impact their value. It's harder than you think to come up with rigorous definitions of growth and value, and the two major growth ETFs are put together very differently. The Invesco QQQ Trust ETF ( QQQ ) is drawn from the Nasdaq 100 Index which has no specific commitment to growth stocks but excludes financials, which have an index of their own. Though not specifically committed to growth, the fact that QQQ is made up of Nasdaq stocks (generally recognizable by their four letter ticker symbols) makes it effectively a growth ETF with a few quirky rules about occasional shifts in company weighting as well as the odd fact that PepsiCo ( PEP ) is its ninth-largest holding.
The Vanguard Growth Index Fund ETF ( VUG ), on the other hand, is put together in a more systematic way starting with the fact that it's designed to be a pure growth fund with carefully chosen criteria developed by the CRSP Indexes (Center For Research In Security Prices) at the University of Chicago Booth School Of Business. The surprise here is how closely VUG and QQQ track each other with QQQ outperforming persistently on most time frames.
Here are the Factors Defining Growth For The CRSP Multi-Factor Model
- Future Long-term Growth in Earnings Per Share
- Future Short-term Growth in Earnings Per Share
- Three-year Historical Growth in Earnings
- Three-year Historical Growth in Sales
- Current Investment-to-Assets Ratio
- Return on Assets
Here are the Factors defining Value:
- Book to Price
- Future Earnings to Price (3 years)
- Historical Earnings to Price (3 years)
- Dividends to Price
- Sales to Price
The estimates for both long- and short-term growth are sourced from I/B/E/S (Institutional Brokers' Estimate System) which derives data from over 18,000 analysts. These I/B/E/S estimates produce crowd-sourced numbers assembled from the Wisdom of Crowds. This works well when dealing with the aggregate performance of an index though occasionally suffering from Crowd Wisdom taken from a Crowd whose members are similar in their knowledge and assumptions. What it mainly assures is that if wrong, at least you will have plenty of company.
One of the important questions to ask about mega cap growth companies is whether they are still properly defined as growth companies. There's an implicit life-cycle in the way their two indexes interface. The most important criterion for growth came as a surprise the first time I saw it and still surprises me a little every time I encounter it despite the fact that it makes perfect sense. Growth and value exist in different time frames. Growth is about the future. Value is about the present.
All six of the CRSP growth criteria convey significant information about the way to evaluate growth companies. The first two attempts to answer the question of how much (and to some degree for how long) the bottom line of a growth stock or collection of growth stocks will continue to grow. The short-term growth really asks how a growth stock will grow on its way to the long term. Items 3 and 4, short-term measures of earnings growth anchor this view to hard facts. Items 5 and 6 provide the present operational measures which should enable rapid growth. It's worth repeating that nothing in the six growth factors includes any measure of valuation, a fact which initially struck me as shocking. After about a decade of reflection on the six factor Growth model I have learned to trust that it's a better model than any alternative I can come up with.
In the Value model is price and valuation are involved in all five criteria. Note that the terminology reverses common practice (price-to-book value, for example, becomes book value to price, making both comparable to dividend yield.) What jumps from the lists, at least to me, is the huge difference in importance of valuation and the time frames. Value stock earnings are only calculated for a symmetrical three years backward and forward and are always measured against the present price. That provides a hint that growth does not quite have zero importance.
One last interesting aspect of the CRSP model is the fact that all stocks are run through both Growth and Value criteria before being placed in the category that fits best. More interesting yet is the fact that a number of stocks rank high enough in both categories that they appear in both indexes. There is in fact a process by which they can "migrate" in stages from one index to the other. Within categories they are ranked by market cap with the result that winners rise in importance, especially so in the Growth category. From the investor perspective that means an assurance that they will participate in the rise of growing companies.
Drilling Down On The Prospects And Valuations Of The Magnificent Seven: The Tech/Growth Three
One can make the argument that the Magnificent Seven are not exactly techs and not all exactly tech/growth companies. Only Microsoft, Nvidia, and Amazon check off both boxes: Being techs and clearly defined growth companies. These three check off all six growth factors. Nobody would mistake them for value companies and attempt to measure them by comparing price to sales, book value, historical or three-year future earnings, or dividends. In both cases you as an investor are in it for the long haul and don't want to be too finicky about comparisons like that. You might, however, steal a quick glance at NVDA's P/E of 54 and MSFT's P/E of 34 and note that this difference is consistent with Microsoft's slightly less than 20% growth rate. NVDA's growth rate is higher but quite a bit lumpier. Both have modest dividends.
Nvidia has been the strongest performer of the Magnificent Seven so far this year, deservedly so because it has had the fastest growth. In this excellent June 24 article Aswath Damodaran points up the high ratio of capital expenditures to sales (which he prefers as a measure instead of the capital expenditures to assets ratio used in the list of Growth Factors). That's a change I agree with for tech companies with less meaningful tangible assets. The problem with NVDA is that it has done so well that everybody knows it and the market has priced it in as if every possible good thing will come to pass. Its price to sales ratio is an absurd 42, higher than the 34 at its previous peak, and assumes that new opportunities in AI are going to come mainly to NVDA which admittedly has done well in the past using high quality semiconductors to be the big winner in industries like gaming.
Microsoft is steadier than Nvidia with a persistent growth in sales not far below 20% and it has broad exposure to the major areas of technology. It has a price to sales around 14-15, high but more reasonable at a third that of NVDA. Why the focus on sales? It's the metric with numbers hard to distort and hype. A quick glance at sales will tell you if a growth company is doing well or not. In the case of MSFT its continuing steady sales growth may make it the most likely of the Seven to outrun falling valuations with steadily rising sales and earnings. It has 40 years of history as a publicly traded company that stands behind this belief.
The anomalous and most intriguing of the tech/growth three is Amazon. In one of its businesses it's part of the relatively mundane and low growth/low margin business of retail. Its major competitor in retail is Walmart ( WMT ). This accounts for its price to sales ratio of 2.5. While innovative retailers enjoy rapid growth in their early days neither Walmart nor Amazon have retail businesses which fit the list of Growth Factors which taken together basically say to cover your eyes and ignore anything you notice about valuation. It's all about rate of change, how fast and how durably you increase sales, earnings, and cash flow, and it's the second major business unit of Amazon which provides that. Nevermind Amazon's 86 P/E (I cheated and glanced at it). The persistent compounding from Amazon's AWS business will outrun the continuing decline of valuation metrics for the foreseeable future.
The Two Members Of The Magnificent Seven Which Are Actually Consumer Companies
Apple makes beautiful communication products. Tesla makes cars. Both Apple and Tesla have a lot of technology underlying their elegant aesthetic surface, but it's the image - both the physical image of their products and the and the public relations image - that has provided a winning formula. In both cases buyers will pay up for the products because of their dominance in a space where both beauty and technological excellence matter.
Up to this point the combination of these two factors has been enough to fight off competition from a group of competitors who have not found it difficult to replicate their basic products. As a result they exist at risk of a major mistake that could shift public perception. Their achievements have an upside and downside. Tesla now has the four leading domestic car brands, an important achievement but also a reminder that it is, after all, a car company. Over two years its price to sales ratio has fallen from 25 to 10 (still a very high ratio) showing that the market has mixed feelings as to what Tesla is. Its P/E ratio is a still astronomical 69, a number which reveals the relatively low ratio of earnings to sales, a problem which Tesla's CEO is currently trying to address. To do so he seems willing to make TSLA more like an ordinary car company.
Apple, meanwhile, has a P/E not far removed from the P/Es of companies like Coca-Cola ( KO ) and McDonald's ( MCD ), both of which were once growth stocks but which have become popular dividend stocks with little or no top line growth. Is that the future for Apple? For the past decade AAPL has had a somewhat lumpy single digit growth rate with decent shareholder return through buybacks and a small dividend, but the fact that I'm talking about it in these terms and comparing it to KO suggest that it's beginning to fit into value characteristics.
The Two Members Of The Seven With Which Growth May Not Keep Up With The Decline In Valuation
Alphabet/Google and Meta/Facebook have striking similarities including the fact that both renamed themselves as part of an effort to diversify away from a single business - advertising - in which they compete directly with each other. While Meta Platforms had some success with Instagram and WhatsApp and Alphabet with YouTube neither has had major success with escaping the importance of advertising. In 2021 Facebook still got 97.5% of its revenues from advertising leading CEO Mark Zuckerberg to make the one-man decision to change the name to Meta Platforms and take a huge and disastrous financial plunge into the metaverse. Alphabet has been similarly unsuccessful with most of its other "bets" while stories have come out about the frat-boy attitude toward women and dismissal of employees who don't share an ultra-liberal political view.
Both Alphabet and Meta Platforms have experienced a decline in top line growth over the past few years while threats from government agencies about anti-competitive practices complicate efforts to realize more revenue from advertisers. By the beginning of 2023 Meta was selling at 12 times earnings, although its 100% rally for the first half year has doubled that to 24. The P/E of Alphabet has fallen from the 30s two years ago to 22. It came as no surprise to find that Meta is now in the Vanguard Value Index ETF ( VTV ) and raises the question about how soon Alphabet will find itself there. In his discussion of Nvidia, Aswath Damodaran noted that he had fortuitously bought NVDA at the low after it dropped 50% in 2022 and was currently debating whether to take profits. That's a hard question with a persistent winner like Nvidia because it leaves a second question as to where you jump back in. The question is tougher with Alphabet, which is up more than 100% from where I bought it but much less likely than Nvidia to drop a bit and then be off to the races again. I continue to wonder whether I should use its 30% rise this year to take profits and turn some my profits over to the IRS. I just looked around my desk for the scrap of paper that asks, "Should I sell Alphabet today?"
The Bottom Line
Hats off to the Magnificent Seven but I'm not a buyer here. I think the main reasons for their leading the market so far this year are the three simple arguments in the first section of this article:
- Quality as mainly displayed in low debt and strong cash flow assuring that they will survive and likely do well in the future.
- They're all well positioned to maintain or increase revenues, earnings, and cash flow regardless of what the economy does. This is a very very major virtue in a stock.
- While future interest rates are uncertain I lean in the direction of believing that they will eventually settle back with a continuing decline in inflation. There are several arguments I could make for this and I will do so in a future article. Low rates increase the value of future earnings of the Magnificent Seven.
My favorites of the seven are Microsoft and Amazon, and I would buy either or both if their revenues, earnings, and cash flows continued to rise at the current rate while they had a 20% correction. That would be an excellent set up for the invisible advantage of growth discussed in the second section above.
I don't think I'll buy Nvidia any time soon. Too many doubts and uncertainties all of which must be resolved favorably to justify its price. Will AI actually make all the money that many investors expect? I won't argue that it won't, but I can say with certainty that I just don't know. Nvidia may well sweep the board, but the certainty is not sufficient for a company selling at 42 times sales.
I will continue to take the CRSP Growth and Value Factors Models very seriously, especially remembering that Growth is about the future and Value is about the present. I also will remember that it's not very helpful to look at ratios of various metrics to price when considering growth stocks. I will, however, continue to throw in my own idiosyncratic estimates of the long term future to accompany the 18,000 I/B/E/S "Wisdom of Crowds" analysts. I also will sneak a glance at ten year backwards sales growth from time to time.
I'll probably sell Alphabet soon, but not today.
For further details see:
Value Vs. Growth: Does The Leadership Of The Magnificent Seven Make Sense?