How to Safely Re-Build Your Equity Exposure

Posted: January 19, 2021 | by: Thomas F. McKeon, CFA

If the market panic of 1Q-2020 caused you to make some emotion-driven "adjustments" to your asset allocation, we have some thoughts about how to re-deploy into stocks.

If the sharp market decline of 1Q-2020 caused you enough anguish that you reduced your exposure to equities, yet still need greater equity exposure to meet your long-term return goals, we have a suggestion about how to prudently re-build your equity exposure back to your target weight.

 

Growth versus Value

Revisiting a market phenomenon we have written about previously at some length, value stocks have lagged the performance of growth stocks by a very large margin for well over five years. Morningstar recently reported that the widest disparity in growth to value performance ever recorded was in 2020, with the Large Cap Growth Index gaining 39% in 2020 while the Large Cap Value Index gained a meager 1.0%, capping off a five-year advantage.

 

The Evidence

As related by Morningstar’s John Rekenthaler, the Morningstar Large Growth Index now trades at a price to earnings multiple of 45.2. Meaning investors are now collectively willing to pay $45.2 for every $1 of current earnings…almost double the multiple of 2015. Two possible explanations for this drastic price increase: growth companies will experience more rapid growth of revenues and profits in the coming years and the higher price multiple is justified, OR investor exuberance driven by covid-induced boredom and internet access to brokerage accounts. The truth is probably somewhere in-between those two, and probably a little closer to the investor exuberance explanation. Still, it is a Timeless Truth of all investing that high prices lead to low returns (or losses) and the inescapable gravity of mean reversion will constrain the future returns of “growth” market exposures.

 

Margin of Safety and Mean Reversion

Over the long-term, the subset of stocks with a growth profile and the subset of stocks with a low-valuation profile deliver the same average return. In the short-term, investors collectively favor different stock profiles at different times: growth, valuation, momentum, dividend yield, etc. As the market panic of 1Q-2020 so clearly demonstrates, investor emotion drives much of the short-term action in the markets. As investors collectively drove equity market prices down more than 30% in 1Q-2020, it set the stage for fantastic returns for the balance of 2020. While the market rally through year-end 2020 was as large as it was unexpected, investors who held or established equity positions in late 1Q-2020 participated in a broad-based equity market gain of more than 50%. The converse of the aforementioned Timeless Truth is also true: low prices offer both a margin of safety and the potential for outsized gains. In the equity markets, stocks with low valuations also tend to provide a hefty dividend yield, so patient investors collect above average income while they hold “value” equity exposures.


What’s Good for the Goose…

Even for fully invested portfolios, a current bias toward value makes sense, and prudent, rules-based portfolio re-balancing away from expensive growth stocks into more sensibly valued “value” stocks offers the potential to avoid some of the probable sub-par future returns of growth stocks and participate more fully in the probable superior total return (gains plus income) of value stocks as today’s laggard becomes tomorrow’s darling. We use the conditional “probable” as there are no guarantees in the rough and tumble world of investing. All of the above is appropriate for new money that needs to be invested in the listed markets.

 

Is This a Growth Bubble?

Equity investing can never be riskless. And in our current low-interest environment, most investors will need some equity exposure to meet their long-term objectives. The sensible and prudent way to own equities is by paying close attention to valuations and avoiding the exuberance of the crowds and sticking to a valuation-disciplined, policy driven approach. Are growth stocks in a “bubble?” Only time will tell. But their valuations make them relatively unattractive.

 

Following the Evidence into Value

With the 1, 5, and 10 year disparity in the returns of growth and value stocks, investors have an opportunity to either rebalance away from overly optimistically priced growth stocks and/or initiate or rebalance into far more sensibly priced value stocks that provide the added benefit of superior dividend income. This bias towards inexpensive, dividend-paying stocks is probably the most prudent way to re-build, re-balance or initiate equity exposure in the current environment.

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