McMurtry Investment Report Newsletter – September 2019

Last month equity markets experienced a sharp rotation out of growth momentum stocks into value ones. At one point during the month value stocks had outperformed growth ones by as much as 5%, before easing off somewhat by the end of the month. Investors were switching out of technology and communication service stocks like Microsoft, Visa, Facebook, Netflix and Google into areas of the market that have not yet participated in this market upturn.

In addition to the above rotation, the market’s safe sectors, Consumer Staples, Reits, Telcos and Utilities also had a sharp correction with investors shifting to more undervalued sectors like Financials and Materials.

There are many reasons for this market rotation. The principle one is that both the growth and safe sectors had market valuations that were not cheap by any measures. Secondly growth sectors in particular do not perform well in an economic recession and market downturn with their high valuations. Lastly hedge fund managers had massive short positions in the value sectors and were leveraged on the upside in the growth sectors. At some point their aggressive positions needed to be unwound and last month was when they decided to do it. This involved buying back their short positions in the value sectors causing their share prices to rise dramatically. At the same time these hedge funds were taking profits in their growth stocks to pay for their new purchases of value stocks.

Historically growth sectors have outperformed their cheaper value ones by a wide margin over the last five and ten year periods when one looks at the performance of the Russell 200 Growth ETF IWO compared to the Russell 2000 Value ETF IWN.

Typical value sectors include Financials, Energy, Materials, Industrials and Consumer Discretionary. Many value investors use price / book value to determine which stocks fit into value or growth. Unfortunately, book values do not always represent the most accurate measure of value as some industries value some assets like real estate at the lower of cost or market value. In addition, many capital investments are expensed on the Income Statement and not reflected accurately on the balance sheet like Research and Development.

In my opinion, the real issue with value stocks underperformance lies with lack of any real and sustainable secular growth in revenues and earnings. Investors will pay for growth as long as it is sustainable and not simply cyclical. In the Consumer Discretionary sector retail stocks have been decimated over the last decade by larger and more innovative players like Amazon, Wal Mart and Costco. Apart from the reasons mentioned above with hedge funds, the only reason an investor would switch into a value stock in a sector that is not growing is that they believe there is hidden value in a stock from assets that are undervalued on the balance sheet. For example, the overall profits of HBC continue to decline yet the stock has recently had a nice move up based on real estate assets that have not been accurately reflected on the balance sheet.