Has tide finally turned in favor of ‘value’ stocks?

The third quarter of 2019 marked the first time since 1997 when the S&P 500 had a total return greater than 20% in the first nine months of the year. While we at Kirr Marbach & Co. are pleased to see an end to the 21-year streak of sub-20% returns for the first three quarters, we’re even more encouraged that the relative performance pendulum began to swing strongly from “growth” toward “value” in September, a trend we hope continues.

According to Ben Graham, Warren Buffett’s business school professor and mentor, “though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run.” What this means is fear and greed play important roles when votes are being cast, but fundamentals are what matter and eventually determine stock prices.

The past five years in particular have been extraordinarily difficult for active “value” investors like us. We believe that to produce better-than-average long-term results, you need to own a portfolio that’s different than the average. We evaluate companies as if we’re buying the entire business. We look for stocks our analysis says trade at a reasonable discount to what that business is worth and have a future catalyst in sight to narrow that gap.

While we firmly believe that strategy is sound, it has certainly not been rewarding recently. We’ve been frustrated that stocks we buy at cheap valuations (i.e. could double and still be attractive) have struggled while stocks with absurdly high valuations (i.e. not profitable anytime soon and could be cut in half and still be overpriced) have soared. However, a shift in fortunes may have begun in September, as the S&P 500 Value index dominated the S&P 500 Growth index, leading to a solid outperformance by value in the third quarter.

One good month/quarter for value obviously doesn’t necessarily mean a good turn in fortune for value has begun. There have been false starts for value before. Still, a shrimp cocktail looks like a feast to a starving man, and we’re seeing some cracks in the “growth at any price” fan base and a long-overdue return to sanity by investors.

Trouble in FAANG-land could mark a top for the mindless, passive indexing fad. Shares of the FAANG stocks—Facebook, Apple, Amazon, Netflix and Alphabet (parent of Google)—have enjoyed tremendous upward momentum. Their ever-increasing prices have led to continually higher capitalization-weights in indexes like the S&P 500 (these five stocks are 1% of the stocks in the S&P 500, but account for a whopping 20% of the capitalization weight). That, in turn, has led to constant buying by mindless, passive indexers attracted to the performance and the misleadingly “free” cost of index funds.

It’s no coincidence that Morningstar recently reported that passive index funds had overtaken actively managed, stock-picking funds in assets for the first time, $4.27 trillion vs. $4.25 trillion. Further, in the past decade, passive index funds added $1.36 trillion in net flows, while actively managed funds shed $1.32 trillion.

Trees don’t grow to the sky, and thorny issues have arisen that threaten to interrupt this fairy tale. Technology giants like Facebook and Google are targets of increased governmental regulation, as lawmakers worry about abuses that accompany these companies’ growing power. The roster of companies seeking to eat some of Netflix’s streaming lunch grows by the day. The upshot is Facebook ended the third quarter down 18.1% from its July 25, 2018, high; Apple down 3.5% from its Oct. 3, 2018, high; Amazon down 14.9% from its Sept. 4, 2018, high; Netflix down 36.1% from its July 9, 2018, high; and Google down 5.8% from its April 29, 2019, high.

It’s an interesting coincidence the very stocks that have powered the performance of index funds are stumbling just as index funds have surpassed actively managed funds in assets. It will be equally interesting to see what happens if/when the capital that has flowed into passively managed funds heads for the exit and mindless buying turns into mindless selling, leading to even more mindless selling. At that point, “sell to whom?” will be the trillion-dollar question. We’ll bring the popcorn!

Buffett famously said, “You only find out who is swimming naked when the tide goes out.” The tide may indeed be going out for the overpriced/overhyped/over-owned technology darlings, public and private.•

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This column was excerpted from Kirr Marbach & Co.’s third-quarter client letter, available at www.kirrmar.com. Kim is the chief operating officer and chief compliance officer for the firm. He can be reached at 812-376-9444 or mickey@kirrmar.com.