From the Waterfront : May 2017  Update

After value stocks and small cap stocks outperformed in 2016, the pendulum has swung back to large growth in 2017 and in a big way.   Through the end of May, the Russell 1000 (large cap) Growth is up 14.29% YTD while the Russell 2000 (small cap) Value Index is down 2.86%.[1]   Just last month, the Russell 1000 Growth was up 2.6% while the Russell 2000 value was down 3.11%.[2]   Those are big differences.   Historically, small cap value has over time outperformed other domestic stock market asset classes.   However, for the past 15 years large growth has beaten out small value.  

A big part of the outperformance has been driven by widely known large cap companies.   There is a tremendous amount of confidence investors are placing in “leverage in the business model”.  Investors are stating, “It doesn't matter what the company earns now because once the network of members is large enough, it can raise prices.”   Therefore, investors are focusing on metrics like user numbers and subscriptions.   Can Netflix raise monthly fees by 20 to 40% without losing many subscribers?  Probably, but it is far from certain.   Can Amazon raise its Prime membership fees and raise fees to third parties selling on Amazon sometime in the not too distant future to generate profits?  There probably is room there but Amazon needs massive operating leverage (profit growth in excess of revenue growth) at some point.  Web services are still a smaller part of the business.   Are Google sites and Facebook sites such wonderful places to advertise that not only will they take share from TV, they will be able to continuously raise prices for ad placements?  Perhaps, but anecdotally, I don't know of many people who actually make purchases from ads presented to them on social media sites.  Raising prices for top of the page web searches seems to have more leverage.   Will cloud software and the promise of continuous recurring subscriptions allow companies to scale back investments in the sales force while at the same time raising prices to the subscriber base and generate massive operating leverage?  The most mature large pure cloud software company, Salesforce, just reported a quarter with approximately 24% revenue growth and 24% growth in SG&A.[3]   No leverage there yet. 

Investor perception is one where companies that have created software networks of sticky users are far superior companies that sell goods or services or even software that is not on a recurring subscription.   Microsoft was until a few years ago thought of as a no growth PC software company but now since it is one of the premier IAAS, PAAS and SAAS (Infrastructure, Platform and Software as a service) companies its earnings multiple has soared.  Microsoft has shown negative Gaap earnings growth and minimal non-Gaap earnings growth over the past few five years.   Almost the entire stock price return has come from a rising earnings multiple. 




The network effect is powerful and companies with strong growing software networks of users will most certainly experience better growth than other industries.  However, since there has never been a time period whereas the value of so many companies is based on a technology focused network of users and the perceived earnings those companies will garner from those users, risks are abound.   Additionally, many of companies creating powerful networks of users treat stock comp or unearned revenue as true free cash flow and have reported earnings numbers that now are attracting SEC attention.   

While many of the goods producing and selling industries are treated as inferior to the software networks these same goods are advertised and sold on and rightfully so, we are wary valuations have diverged too much.   Our allocation to value stocks/funds will likely increase in the near future.


Chris Harrington

Chief Investment Officer


[1] bloomberg

[2] bloomberg

[3] bloomberg




Chris Harrington

Chief Investment Officer


The views expressed by the author are his own and do not necessarily reflect the opinion of Wells Fargo Advisors Financial Network or its affiliates.


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