The Starting Gun Just Fired

The starting gun just fired... Growth is no longer dominating value... Many growth stocks could be in for a rude awakening... No matter what happens, value stocks will outperform... Don't overlook this when searching for value stocks...

The starting gun just fired for the new 'Golden Age of Value'...

As my good friend and Extreme Value editor Dan Ferris noted a week ago in the Digest, the key turning point happened earlier this month. From the September 17 issue...

It's like the change of the seasons, and I've just noticed that the first leaves are turning... A brand-new "Golden Age of Value" began on Monday, September 9.

As our friend Jason Goepfert reported at SentimenTrader.com, that day saw the biggest one-day shift in momentum since 2009 between the best-performing stocks year-to-date ("YTD") and worst performers. Simply put, the worst performers YTD performed best that day, and the best performers YTD performed worst.

Of course, the best performers YTD have been the best performers of the past decade. These are the big, fast-growing businesses that trade at high valuations. The worst ones are the opposite... slower growing and cyclical, with cheap valuations.

In other words, fresh investment capital is finally flowing out of growth stocks – the best performers over the past decade – and into value stocks. As a result, "boring" businesses that investors have long neglected will offer some of the best investment opportunities over the next year.

Today, I (Mike Barrett) will explain why the rotation from growth to value is happening. And more important, I'll show you why value stocks will outperform growth stocks whether earnings rise or decline in the months ahead...

But before I get into the details, I must be clear about what I mean by 'growth' and 'value'...

In this essay, I'll use two exchange-traded funds ("ETFs") to represent the two groups of stocks – the Vanguard Mega Cap Growth Fund (MGK) and the Vanguard Mega Cap Value Fund (MGV).

Over the past 70 years, U.S. gross domestic product has averaged 3.2% per year.

But the growth-stock universe includes businesses that grow their earnings per share ("EPS") at a much faster pace... Often, their EPS growth is between 20% to 50% per year.

Well-known companies like Amazon (AMZN), Netflix (NFLX), Adobe (ADBE), Visa (V), and PayPal (PYPL) are all growth stocks... Each is held within MGK. The ETF's portfolio of 124 growth stocks has averaged 25.6% in annual EPS growth over the past five years.

When companies grow earnings at such a high rate, it means they're enjoying strong demand for their products and services. It makes sense to keep the pedal to the metal... And that's what they do, reinvesting rising earnings back into the business to grow further.

On the other hand, the value-stock universe includes businesses that grow their earnings at or near the rate of the broader U.S. economy. Today, MGV's EPS growth rate is just 2.3%. That's less than one-tenth of MGK's rate... And it's in line with the broader U.S. economy during the second quarter of this year.

Top holdings among the 156 stocks in MGV include Procter & Gamble (PG), Verizon (VZ), UnitedHealth (UNH), and Coca-Cola (KO). These companies have fewer growth opportunities to reinvest in, so they typically use their free cash flow ("FCF") to pay higher dividends. That's why MGV's 2.8% dividend yield is two and a half times more than MGK's 1.1%. (Regular Digest readers know FCF is the money left over after a company pays its operating expenses and capital expenditures.)

Growth stocks have outperformed value stocks over the past decade, but the gap is closing...

You can see what I mean when you compare the total returns of MGK and MGV over the past decade. Take a look at their performances over these four different time periods...

No one reading this essay should be surprised that growth stocks trounced value stocks over the past decade... After all, big-cap technology darlings Amazon and Netflix are up roughly 2,000% and 4,000%, respectively, in that span.

But if you look closer at the previous table, you'll notice that MGK hasn't outperformed MGV by as much in recent years. Most of MGK's outperformance happened at the beginning of this cycle. Over the past year, the returns of MGK and MGV have been essentially the same.

Capital is moving back into value stocks for a good reason...

Whether earnings growth continues to decline or reaccelerates, value stocks are likely to outperform growth stocks going forward.

We've seen a period of slowing earnings growth across the market so far this year...

The EPS for all the companies in the benchmark S&P 500 Index has declined in each of the past two quarters. And of the 113 index members that issued EPS guidance for the current quarter ending September 30, 73% have lowered their previous expectations. That's slightly above the five-year average of 70%, according to market-data firm FactSet.

Because these companies are lowering their EPS projections, FactSet estimates that the S&P 500 could see a year-over-year EPS decline of 3.8% in the third quarter. That's much worse than the 0.6% decline in the second quarter... And it would mark a significant EPS deceleration. If this situation plays out, FactSet said it would be the first time the S&P 500 has reported three straight quarters of year-over-year EPS declines since 2015-2016.

And as you can see in the following chart, this period of EPS deceleration is even more pronounced with some of the market's top growth stocks. Take a look...

An earnings slowdown isn't surprising...

After all, one of the best economic indicators out there – the Chicago Fed National Activity Index ("CFNAI") – has signaled waning economic activity over the past year.

The CFNAI is designed to give a comprehensive snapshot of U.S. economic activity. It relies on 85 different growth indicators – including plant utilization, hours worked, home sales, and inventory levels. Its statistically-derived trigger points make it particularly useful...

When the index's three-month moving average and "diffusion indicator" – a measure of how widespread monthly index changes are – fall to less than -0.70 and -0.35, respectively, it signals that a period of economic contraction is likely ahead.

Right now, the latest readings are still comfortably above these triggers (-0.06 and -0.12, respectively), but they're trending lower. You see, at this time last year, both indicators were much higher... at +0.37 and +0.27, respectively.

A global bellwether recently provided the latest proof of slowing growth...

Brie Carere, the chief marketing and communications officer for FedEx (FDX), said during the shipping giant's earnings call last week that it expects global trade volumes to contract this year for the first time since 2009. In response to this slowdown, FedEx – which also reduced its full-year EPS expectations – will retire aircraft to reduce its capacity.

Despite the EPS deceleration and mounting evidence that the trend could continue for an extended period, growth-stock valuations remain stubbornly high today. Investors continue to give these stocks the benefit of the doubt...

For example, as the previous chart shows, Netflix's trailing 12 months' EPS growth plunged from 181.8% to 16.4% over the past four quarters. Yet the company's shares command an even higher price-to-earnings ratio today (144 times) than they did a year ago (134 times).

However, if the shift toward lower EPS growth continues, know this... It's only a matter of time before investors abruptly adjust those sky-high valuations downward. That means massive declines could be in the cards for many over-loved, over-owned growth stocks.

A stock trading at 100 times earnings can fall a lot further than one trading at 15 times...

That's exactly what happened when the last great growth-stock mania imploded roughly two decades ago. The Invesco QQQ Trust (QQQ) – an ETF that tracks the tech-heavy Nasdaq 100 Index – lost about 85% of its value in less than 24 months, plunging from a valuation that topped 100 times earnings.

Meanwhile, the stodgy, old Dow Jones Industrial Average held up far better... Thanks to boring value stocks like 3M (MMM) and Johnson & Johnson (JNJ), it only lost 34% over a similar span.

But it's little consolation to outperform growth stocks and still lose 34% of your capital. To really appreciate the benefit of owning value stocks during a big earnings-driven meltdown, you have to consider how things played out during the ensuing recovery...

Many high-flying growth stocks – like Pets.com and eToys.com – didn't survive the dot-com collapse from 2000 to 2002. Others – like Intel (INTC), Cisco (CSCO), and Corning (GLW) – survived... But nearly two decades later, they've yet to reach their 2000 highs.

On the other hand, value stocks like 3M and Johnson & Johnson quickly recovered. They even went on to set new highs in 2002... and have yet to look back. Today, 3M and Johnson & Johnson are up about 315% and 230%, respectively, from their October 2002 lows. (In Extreme Value, we recommended Johnson & Johnson about nine years ago. It's up 156% since then.)

Now, that doesn't mean you should load up on shares of 3M and Johnson & Johnson to protect yourself from the next big bear market. I'm simply pointing out how owning slower-growing, boring value stocks can help you outperform when growth is broadly decelerating.

When high-flying growth stocks slump, higher dividends also attract capital to value stocks...

A strong, growing dividend of 3% or better looks increasingly attractive when growth stocks are getting creamed and bond yields are low (and likely headed lower).

That's why, in the September issue of Extreme Value, we reminded subscribers not to overlook energy-infrastructure giant Kinder Morgan (KMI). The stock is up 18% since we initially recommended it in September 2018.

Kinder Morgan has America's best and most extensive energy infrastructure footprint. It owns 70,000 miles of pipelines, which handle about 40% of the natural gas consumed in the U.S.

More important, the company's vast energy network continues to grow... creating new sources of cash flow that give management confidence to aggressively raise the dividend.

This year, the company's annual dividend is up 25% to $1. Management has already committed to raising it another 25% next year to $1.25 per share. And we believe there's an excellent chance that a third straight 25% rise in 2021 would increase Kinder Morgan's annual dividend to $1.56 per share.

That means any capital you invest today at a share price of $21 or lower (our current "buy up to" price) could be earning more than 7% two years from now. Plus, the value of the shares you hold could also be much higher by then if the company's stock continues to trade at its current dividend yield.

Even if EPS growth bounces back from the current downtrend, we still believe value will outperform growth...

Based on its analysis of previous cycles, Bank of America Merrill Lynch believes U.S. stocks could surprise to the upside after bottoming later this year. That's because the investment bank forecasts that corporate earnings will reaccelerate into 2020.

But the thing is, if that were to happen, it would create an even better reason to rotate into value stocks. Savita Subramanian, Bank of America Merrill Lynch's head of U.S. equity and quantitative strategy, says this is when value typically outperforms growth.

If you look back a couple of years, you'll see a great example... Investors became giddy about the promise of e-commerce – and Amazon, in particular. In turn, they gave up on retailers with business models heavily tied to its primary target: U.S. shopping malls.

Abercrombie & Fitch (ANF) was among the victims... From 2011 to 2017, the company's stock plunged from roughly $75 per share down to a 17-year low near $9 per share.

Investors believed this iconic apparel retailer couldn't survive in the era of e-commerce. But they were wrong...

As you can see in the following table, Abercrombie's EPS gradually improved over the next three quarters. And as that happened, the company's price-to-sales ("P/S") ratio more than doubled...

The combination of accelerating EPS and a sharply higher valuation translated into a soaring share price... In just nine months, Abercrombie's stock jumped 211%. That performance trounced the S&P 500 (7%) and MGK, the growth-stock ETF (13%), over the same period.

In short, Abercrombie – a so-so business that most investors had left for dead – strongly outperformed almost every other stock (including many high-quality ones) as earnings growth accelerated and investors sharply adjusted their valuation of those earnings upward.

Now, no one – including Subramanian – can say for sure if earnings will accelerate into 2020 or not... But it could certainly happen if interest rates stay low and we see a sudden resolution to the trade standoff between the U.S. and China.

Value stocks are likely to outperform growth stocks if EPS growth accelerates due to valuation differences...

The market's most neglected stocks have plenty of room to re-rate much higher if EPS growth turns higher. That isn't the case with many growth stocks, whose valuations have remained persistently high for the better part of the past decade.

In his classic book, The Most Important Thing, legendary investor Howard Marks urges investors to chart a different course if they want to outperform the market...

The key is who likes the investment now and who doesn't... The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.

In Extreme Value, our first three 'Golden Age of Value' recommendations embrace this thinking...

Each company is a leader in its respective industry. But despite expectations of an earnings acceleration into 2020 and 2021, all three trade at low relative valuations.

All three companies also pay dividends. (One currently yields almost 6%.) And highly experienced management teams run all three companies. These folks know how to survive economic downturns... and then thrive afterward.

One of these Golden Age of Value recommendations is also likely to create additional value for its shareholders by spinning off one or more market-leading divisions in the future.

And as I said, we just heard the starting gun for the Golden Age of Value. So we're just beginning... Dan and I will be on the lookout for other great companies to add to our Extreme Value model portfolio in the coming months. I encourage you to come along for the ride... (To become an Extreme Value subscriber and access all of this research right now, click here.)

And you can do something else right now to gain an edge...

If you want to see the biggest gains during the Golden Age of Value, you must be able to tell which stocks deserve their poor valuation... and which ones investors are shunning for no good reason.

That's why you should tune in for Professor Joel Litman's big event tomorrow night...

As Digest readers have learned over the past several days, Joel is a forensic accountant who believes deep flaws in standard accounting keep investors from understanding the real value of many stocks. Valuing these companies solely on data in financial statements can be misleading.

Joel employs a team of more than 100 accountants and researchers to figure out the "true" value of thousands of publicly traded companies around the world. Joel and his team take apart the financial statements. Then, they put them back together using a set of standards that removes the flaws... Joel and his team make more than 130 adjustments in their process.

In 2015, Joel's system uncovered hidden value in chipmaker Advanced Micro Devices (AMD). The stock is up more than 1,000% since he found an opportunity in it. Some of Joel's other big winners include Planet Fitness (PLNT), Etsy (ETSY), and RingCentral (RNG).

Joel has provided his research to professional investors for a decade. But now, he has created a way to let individuals access his work and use his system to value almost any stock in the market. He calls it his "Investment Truth Detector."

Joel will introduce his remarkable system to individual investors like yourself in a little more than 24 hours. Tomorrow night, beginning at 8 p.m. Eastern time, he will walk everyone – including Porter, who will take part in the online event – through how to use it.

It's free to attend. You don't want to miss it... Reserve your seat right here.

New 52-week highs (as of 9/23/19): Axis Capital (AXS), Celgene (CELG), Lundin Gold (TSX: LUG), New Pacific Metals (NUPMF), Procter & Gamble (PG), and ProShares Ultra Utilities Fund (UPW).

In today's mailbag: Bryan Beach responds to a subscriber who called his recent Digest "easily the worst daily report in 8 years of reading." Send your comments and questions to feedback@stansberryresearch.com. Remember, we can't provide individual investment advice, but we read every e-mail.

"Bryan, you have to turn in your accounting badge since you obviously never learned anything in the time you were an accountant. If you want to state that a company's finance picture is different than its accounting one, I understand. But as a CFO for 25 years in a company where those [generally accepted accounting principles ('GAAP')] procedures are used by management to efficiently score and manage the business, I can only wonder what went wrong with you. Easily the worst daily report in 8 years of reading. Why don't we just go back to cash basis accounting in your world? If you think accrual accounting is manipulable, try cash basis – don't pay any bills in December. Idiotic. All financial methods are manipulable – find one that works and run it using GAAP principles like materiality and consistency. Blame the idiots not following GAAP ideals, not GAAP. Cash flow is an important part of a business, but so is net income. I don't know where you went to school, but based on your article they should rescind your degree." – Paid-up subscriber George C.

Bryan Beach comment: Let me start with a clarification... I believe in the basic principles of GAAP accounting. In most cases, they offer a good representation of accounting reality and are useful in managing a business. I am not advocating for a widespread switch to cash-basis accounting.

With that said, I'm critical of many components of GAAP. I'm not alone in that... I've never met an accountant who thinks GAAP is perfect, and I doubt you have, either. The problem is, while accountants quibble about the details, they miss a much bigger issue...

Large portions of the investing community find GAAP accounting almost completely worthless.

This is a big problem – especially in public companies. That was the point of my Digest last Thursday.

You asked where things went "wrong" with me. I don't know for sure, but I have a theory...

I've been an investing junkie and newsletter nerd for as long as I've been an accountant. When I was the director of a public company's accounting department, I always hated that the GAAP financials and SEC filings I worked on during many nights and weekends were roundly ignored by the Wall Street analysts who covered our company.

It was disheartening and disappointing on a personal and professional level. So I began to question things...

Have you ever wondered why Wall Street analysts' calls begin with a two-minute legal disclosure from the company explaining that they will generally only be discussing non-GAAP numbers? They wouldn't do that if they found GAAP to be adequate. That's odd, right?

As I mentioned Thursday, legendary investor Warren Buffett has been a vocal critic of various GAAP accounting metrics for most of his six-decade career. A litany of value investors like Mohnish Pabrai and Seth Klarman have come to the same conclusion. So has the faculty at the Columbia Business School, along with a New York University Stern School of Business professor, who wrote a book in 2016 arguing that GAAP accounting is irrelevant.

Perhaps something went "wrong" with all of them, too? Shall their degrees be rescinded as well?

Look, I don't necessarily agree with all these critics on all their points. I'm only pointing out that I wasn't exactly going out on a limb to suggest GAAP methods are flawed.

Internal management notwithstanding, the entire accounting profession has gotten itself into a big mess as it deals with the investing public...

Companies began providing certain non-GAAP adjusted numbers because that's what the investment community demanded. It wasn't ideal... but it worked.

But companies have gradually started sneaking non-GAAP adjustments into their financial statements that obscure – rather than illuminate – financial reality. Now, the SEC is demanding more disclosure and consistency around non-GAAP reporting.

This leads to a frustrating dilemma for individual investors. How do you tell the useful non-GAAP adjustments from the self-serving, deceitful ones?

Analysts and investors must come up with their own way to measure a business' results and prospects...

Like many others, I prefer to look at the statement of cash flows. As I explained Thursday, I make "a couple of minor adjustments and looking at two to three years' worth of cash flows." By looking at cash flows in rolling periods of two to three years, I'm effectively smoothing out the lumpiness that otherwise comes from focusing on cash-based accounting.

This is why I find Professor Joel Litman's new ideas so intriguing... and why I will be listening in tomorrow night. I'm sure I won't agree with everything Joel says – I've never met two accountants who agree on everything – but I love that he is trying to make a standardized financial statement that is useful to both businesses and investors.

Again, if you haven't signed up yet, you should check it out. Click here to get started.

And thank you for the thoughtful feedback, George. I love hearing from readers... even those who don't agree with me. More important, thanks for being a loyal reader for eight years.

Regards,

Mike Barrett
Orlando, Florida
September 24, 2019