Mind the Gap!
“Mind the gap” as they say when exiting the train, is prudent advice for investors too as the rotation from large cap tech to small cap value accelerates. There is potentially a large valuation gap between where growth and momentum investors are beginning to sell growth shares and where value investors might be tempted to purchase these same shares.
The outperformance of the Russell 1000 (large) Growth Index versus the Russell 2000 (small cap) Value index since year-end 2016 is staggering, up 146.13% vs. up 43.73%. (Chart 1). This performance is inclusive of the strong rally in small value vs. large growth since September 2020, with small value up 60.13% vs. large growth up 13.19% (Chart 2)*.
Chart 1: Source Bloomberg
Chart 2: Source Bloomberg
In our view, small value still has considerable upside over the mid- to longer-term vs. large value due to this continuing valuation gap between large growth and small value shares, as well as the recent increase in the 10-year treasury yield which we believe favors small cap value stocks and is a headwind for large growth stocks.
The April 2021 Russell Fact Sheets for the small cap value index (The Russell 2000 Value) and the large cap growth index (Russell 1000 Growth) shows part of this valuation disparity**.
In fact, we believe this summary information actually underestimates the true valuation disparity of large cap growth, as seen anecdotally below with popular growth stock valuations well over the Russell 1000 index, despite significant declines from their 52-week highs***.
Caveat Emptor, or let the buyer beware, is a phrase we have often used to describe our philosophy of purchasing securities with a favorable upside valuation outlook. However, we would caution growth and momentum investors to Caveat Venditor, or let the seller beware. In our view the significant run up in growth shares, spurred in no small part by significant easing actions of the Federal Reserve, have left these shares over-valued and due for a correction. What we think investors don’t fully realize is that even after the first 30%+ price declines in growth shares, the price that value investors may be tempted to purchase these securities is still only a fraction of their trading value. This growth investor sell vs. value investor buy valuation disparity is the significant gap we caution investors to heed. Moreover, as selling accelerates, the quantitative momentum strategies that bought regardless of valuation on the way up, may now bring a tsunami of selling supply as negative price action accelerates.
In our view, the recent rotation to smaller value stocks still has room to run, as earnings should recover with post-Covid business re-openings, and with the favorable tailwind of the rising 10-year treasury, which favors industrials and financials, versus the headwind it provides for large cap growth shares in higher borrowing costs and higher discount rates. In baseball terms, we think we are likely only in the second inning.
* The Russell 200 Value index and 1000 Growth index are both an unmanaged group of securities considered to be representative of the small and large stock market in general, respectively. Indexes are unmanaged and do not incur management fees, costs, or expenses. It is not possible to invest directly in an index.
**Russell fact sheets for April 2021 available at https://research.ftserussell.com
***5/12/2021 Pricing, EPS and Book Value data for Tesla, Palantir and Etsy source from Bloomberg.