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I think most of us have attempted to build a house of cards at some or other point in our lives. A single card is such a light, nearly two-dimensional item, but if you go about it carefully by first placing two sides upright, and then placing your card roof on top, you will have your first house of cards.
From there, you’ll add a few rooms to each side and once the structure is stable enough, you’ll start with your second storey. If you continue to repeat these steps, your house of cards, which started with only one card, will rise higher and higher.
At some point, however, the structure will start to become unstable, but despite this, we have a tendency to keep aiming higher. Eventually, it doesn’t matter how light these cards are, you will always end up regretting that one misplaced card that made your entire house of cards come tumbling down.
Over the last year and a bit, on numerous occasions we had to hear that stock markets worldwide are trading at record high valuations and that it hasn’t been seen in decades. In one of my previous articles, I pointed out to investors that this phenomenon is nothing new, and if history was to repeat itself, this house of cards may still grow higher. Will it become unstable from time to time? Absolutely.
The better question is actually whether all shares worldwide tend to rise up like a house of cards, all at the same time, and the answer is no. When we take a look at the S&P500, for example, up until 19 May 2017, six out of the 11 main sectors in the index weren’t only trading weaker than the S&P500’s growth of 6.4% in US dollar terms (for 2017), but also at an average negative percentage of -1.4% for the year.
Sectors like information technology and media have managed to rise to the occasion after nearly two decades of lagging behind. But will the history of the IT house of cards in late 1999 be repeated, or will this time be different?
This question can actually be taken a bit further, by rather asking whether growth shares as a whole haven’t grown too much over such a relatively short period. Before we discuss this further, however, let’s just quickly define the concept of growth shares versus value shares. According to MSCI valuations, growth shares are classified according to the following five variables: expected long-term earnings growth rate, expected short-term earnings growth rate, current internal growth rate, long-term historical earnings trends, and long-term historical equity growth trends.
Value shares (also according to MSCI) are chosen based on price-to-net asset value, 12-month expected price-to-earnings ratio (P/E) and dividend yield. The latter is typical of the types of shares bought by Warren Buffett, provided that they trade at attractive levels.
When we compare the world’s largest growth shares to the world’s largest value shares, things become very interesting. By examining this ratio over the past 20 years, you will see that growth shares, as they are doing right now, have grown much faster in value when compared to value shares, until it all came tumbling down in 1987. We saw it happen again in the 1990s and we all know how that eventually ended for growth shares.
The historical average P/E at which the MSCI All World Index traded was around 16 times. The same index is now trading at a level of 22.4 times (19 May 2017). By comparison, the value index is currently trading at 19.1 times, while the growth index is trading at a P/E of 27 times.
In light of this, equity investors should take a good look at their portfolios to determine whether their shareholdings are leaning primarily towards growth or value shares.
If driven largely by growth, the portfolio needs to be re-evaluated and potentially overweight positions trimmed down, to avoid building an unstable house of cards.
Schalk Louw is a portfolio manager at PSG Wealth.
This article originally appeared in the 8 June edition of finweek. Buy and download the magazine here.
