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100 life-sized cutouts of Facebook CEO Mark Zuckerberg sit on the lawn of the U.S. Capitol on April 10, 2018.
- Large-cap growth companies have been among the biggest losers of the stock market's declines since early October.
- This trend was to be expected because investors had overpaid for growth stocks relative to their probable future cash flows, according to Daniel Needham, the chief investment officer of Morningstar Investment Management.
- In an interview with Business Insider, Needham outlined what investors should be doing as growth rates and investor returns slowly fall.
Large tech companies were once again at the forefront of the stock market's losses on Monday.
Their slump since early October is representative of the broader decline in high-growth stocks - a group that, until recently, dominated the returns investors earned during this bull market.
Daniel Needham, who oversees $207 billion as the CIO of Morningstar Investment Management, sees their decline as the inevitable outcome of a market that got overpriced relative to sustainable cash flows.
Investors have "significantly overpaid" for growth stocks, creating an unsustainable gap with the broader market, Needham told Business Insider in an exclusive interview.
For proof of this assertion, he points to the question of whether growth stocks are cheap relative to history. Depending on who you ask and what metric you look at - like the ratio of enterprise value to sales, for example - tech stocks have been enriched with dotcom bubble-like valuations during this bull market.
"These are great companies, but what matters isn't what gets delivered - it's what's in the price," he said. "If great companies are priced to be invincible companies, they can be a really bad investment."
What normally follows such exuberance is a slow decline in the growth rates that made the stocks attractive to investors in the first place, Needham said.
Big tech is already showing what happens when expectations get reined in. Facebook, Amazon, and Apple were among the growth companies that missed expectations for growth when they reported third-quarter earnings in October.
The sell-off in growth stocks has helped to lower the lofty valuations that skeptics have been decrying all along. However, this has not automatically created the incentive to buy. Needham noted that while large-cap tech has cheapened, so have other sectors of the market and regions of the world. This means growth is cheaper on an absolute basis, but not necessarily relative to its alternatives.
Investors who have stuck with growth in the nine-year-plus bull market have enjoyed the best returns. That's a reason to be cautious about timing the market incorrectly by exiting too far ahead of the next bear market. Moreover, the biggest gains have historically come in a bull market's latter stages.
Needham's message to investors with this concern is to gradually turn more defensive.
"Even if the rally continues, each incremental return is going to get riskier," he said. "If you're investing for the full range of outcomes, then you should recognize that there's a future that could be quite painful, and so that would warrant more defensive positioning."
He's not advocating for an all-or-nothing allocation to stocks. Rather, investors should figure out how much downside they're willing to tolerate in their portfolios and then invest accordingly.
"The more asset prices fall, the more excited we get," Needham said. "To quote Warren Buffett, not because we like pessimism, but because we like the prices that pessimism brings."
Besides narrowing their gap with the broader stock market, high-growth companies are also on track to curb their outperformance relative to value stocks - or those trading at much cheaper prices relative to their intrinsic worth and fundamentals like earnings, Needham said.
He's not the only investor who thinks value stocks have been so maligned that they're poised for a rebound. Strategists at Societe Generale have also made the case for the resurgence of this investing factor, arguing that value stocks have been an effective hedge against the steepest market drawdowns since the 1920s.
They added that if the mood in global markets continues turning more bearish, value stocks will be appealing to investors who are wary of overpaying for future earnings growth.