Former high school physics students will recall the concept of kinetic versus potential energy. Potential energy is the stored energy of a coiled spring, a drawn bow, or a roller coaster atop a hill. Kinetic energy is possessed by an object in motion the speeding cyclist at the bottom of a hill. A tradeoff exists between the two. When a rubber band can stretch no farther, it has the greatest potential for snapback.
This framework provides a serviceable (though imperfect) analogy for the role of valuation in investing. All other things being equal, cheap assets offer greater return potential than expensive assets. Cheap assets have more potential energy. Conversely, like a roller coaster set to crest a hill, expensive assets may perform well for a time (kinetic energy), but likely have reduced upside potential. For this reason we tilt portfolios toward areas of that market that we believe offer better value.
Todays market is marked by stark contrasts in this regard. The best performing area of the U.S. market is aggressive growth stocks, which are expensive. Among the worst performing areas is emerging markets, which offer compelling valuations and therefore good long-term return potential, in our view.
We believe emerging markets offer the better long-term opportunity for the growth-oriented portion of an investors portfolio. Investors should be cautious toward aggressive growth stocks, despite their outperformance. There has been opportunity cost in 2015 to owning cheaper assets like emerging markets and avoiding expensive areas like aggressive growth stocks, but we believe long-term investors will be well served by focusing on valuations.