Know What You’re Buying!

My long-time partner John Washington always used to say that market trends usually last much longer than anyone expects. One trend that has persisted for quite some time now is the performance gap between growth stocks and value stocks. Growth stocks, as their name suggests, are those that have the potential to grow revenue and earnings at a faster pace than the overall market for any of a variety of reasons. These companies could be operating in industry sectors that are growing faster than the overall economy. Or they could have a more company-specific competitive advantage, like some new technology, superior management, or another factor. Growth stocks tend to be smaller than their value counterparts, and their smaller size provides the opportunity to grow more rapidly from a smaller base. Growth stocks also tend to trade at more expensive valuations (based on various metrics like price-to-earnings, price-to-sales or price-to-book value) to reflect their potential for outsized growth.

Value stocks, on the other hand, are usually companies that are larger, more established, and more dependent on growth in the economy at large as compared to growth stocks. Their dependence on a robust underlying economy makes them more cyclical than the overall market. Value stocks also may have some real or perceived defect, like an execution misstep or a regulatory issue, that might keep them from growing at a faster pace. Their inferior growth prospects cause value stocks to trade at relatively cheap valuations. These cheap valuations tend to attract investors if and when economic prospects improve.

With those high-level definitions, let’s take a look at some numbers. Despite some fits and starts, the economic uncertainty over the past few years has contributed to vast outperformance by growth stocks as compared to value stocks. This year alone, the Russell 1000 Growth index (RLG) has beaten the Russell 1000 Value index (RLV) by well over 9%, excluding dividends. If we go back to the beginning of 2017, which is when the massive divergence began, the Growth index is up 62% compared to just 19% for the Value index. A big part of the strength in growth stocks can be attributed to the so-called FAANG stocks (Facebook, Amazon, Apple, Netflix, Google, and we include Microsoft). On average, the FAANG stocks are up a whopping 115% since the beginning of 2017, accounting for over a third of the total increase in the Russell 1000 Growth index. We show the massive performance variances in the first chart below.

In the next chart, we show annualized performance data (excluding dividends) since the beginning of 2017 for each of the FAANG stocks, and the Russell 1000 Growth and Value indices. Each of the FAANG stocks has appreciated at least 20% annually, with four of the six stocks up well over 30% annually and the average stock up 30% annually. By my estimate, the huge moves in these massive companies contributed about 6% of the Russell 1000 Growth’s annualized return of 18% over the three-year time frame. Over the same time frame, the Russell 1000 Value index was up just 6% annually.

In the table below, you will see that the FAANG stocks have grown in market capitalization to a total of almost $5 trillion, which is approximately the Gross Domestic Product of the third-largest economy of the world, Japan. Two of the six FAANGs have market capitalizations of over $1 trillion, and another two aren’t far behind.

The massive appreciation in growth stocks, and the FAANG stocks in particular, is becoming a big concern. By virtue of their massive market capitalizations alone, a small handful of very large companies has the potential to meaningfully impact investor returns in the stock market. This is especially true for investors who choose to invest in exchange-traded funds (ETFs) that seek to mimic the returns of a smaller sub-segment of the stock market. The Russell 1000 Growth index is one index that appears to be especially vulnerable. In the chart below, you will see the distortions that have been created by the massive outperformance in technology stocks, and FAANG stocks in particular. At the end of 2015 – just four years ago – the information technology sector represented just 23% of the total market capitalization of the Russell 1000 Growth index while the FAANG stocks accounted for about 17%. As of yesterday, the technology weighting in the index had risen to a staggering 39%, with the FAANG stocks accounting for 30% of the total market capitalization!

Passive investing through index ETF’s has grown enormously in recent years. But while passive investing has its place, investors need to be aware that when they buy more esoteric index ETF’s, like those that track the Russell 1000 Growth index, you need to know what you are buying. With a Russell 1000 Growth index ETF, you are buying much larger amounts of stocks that have done fantastically well in the recent past. If you believe investors should buy low and sell high, you aren’t going to be doing that if you buy an ETF that replicates the Russell 1000 Growth index! Instead, you are putting 30% of your money in stocks that have gone up 30% annually on average over the past three years. Are you sure you want to do that?