Value stocks have been underperforming growth stocks since 2007. That’s more than 12 years in a row! But is this underperformance going to last much longer? Or has the market changed fundamentally, and growth will always outperform value investing?
Here is a chart comparing two ETFs that track companies in the S&P500 index:
- iShares S&P 500 Growth ETF (IVW) in blue;
- iShares S&P 500 Value ETF (IVE) in red.
As you can see, in this index alone, value stocks have been lagging behind growth stocks since 2009. If we account for world stocks instead, it’s worse than that.
In this article, we will explore the question of value vs. growth in detail. We’ll rely on research publications to understand the underperformance and what to expect in the future.
Value vs. Growth Stocks
If you’ve been investing in stocks, you’ve likely heard this terminology. Value vs. growth is a hot topic among investors. But what does that even mean?
Proponents of value investing, like Warren Buffet, claim it’s the best way to invest your money. They look for undervalued companies in the market with solid fundamentals that will likely generate a good return in the long run.
On the other hand, growth investing means investing in growth companies – companies that exhibit signs of fast growth. Investors reinvest their profits more aggressively into the businesses to achieve faster growth. This requires investors that believe that future returns will be there at some point and therefore are willing to pay a premium for it and are ok with the lack of dividends.
What Is a Value Stock?
A classic measure of value uses something called the price-to-book ratio (P/B ratio).
By comparing the intrinsic value (objective value) and the market’s value of a company, investors can identify good buying and selling opportunities, which is the core of the value investing process.
A low P/B ratio means we’re looking at a potential value stock. A high P/B ratio means we’re probably looking at a growth stock.
Where we draw the line between the two depends on individual investment strategies and it’s not fixed. Some issuers of value ETFs choose certain metrics, which will likely be different from other issuers.
But there’s one significant issue with this type of measurement. It used to work well when the global economy was heavily reliant on manufacturing and the production of goods. But since then, we’ve moved heavily into a service economy, so P/B ratio alone can be misleading.
Why is that you may ask?
An article published in the Financial Analysts Journal, explains this issue:
For example, intangible investments (e.g., research and development, patents, intellectual property, and so forth) are presumably undertaken because they are expected to add to shareholder value. Yet these investments are treated as expenses and deducted from book value. This leads to many stocks being classified as growth stocks because they have tiny book values due to large investments in intangibles. Many of these stocks would be classified as value stocks if the expected capitalized value of the intangible investments added to the book value.Reports of Value’s Death May Be Greatly Exaggerated
As you can see from above, there are many key activities companies are undertaking to add to shareholder value that are not considered in a simple P/B ratio.
Which Strategy Works Best: Value or Growth?
The correct answer is: it depends. It depends on the timeframe, economic cycles, and much more.
For example, as The Motley Fool reports:
Based on the study findings from Bank of America/Merrill Lynch over a 90-year period, growth stocks returned an average of 12.6% annually since 1926. However, value stocks generated an average return of 17% per year over the same timeframe… Value has outperformed Growth in roughly three out of every five years over this period.Quote from Growth Stocks vs. Value Stocks: Over the Long Term, Your Best Bet Is…
However, if you look at the past 12 years, from 2007 to 2019, value stocks have actually underperformed growth stocks. And that underperformance has been very significant, with a drawdown of -39%. This is comparable to the tech bubble drawdown of the year 2000, which was -40%, but in a much shorter timeframe of 2.4 years, as mentioned in Table 2 of the Financial Analyst Jurnal article.
This long period of underperformance has led to countless articles stating that value investing is dead.
But is it really not worth investing in value stocks anymore? To answer that, we first need to understand what caused this underperformance.
Why Has Value Investing Been Underperforming Growth?
There are many different narratives used to try and explain this underperformance, as mentioned in this study. Let’s briefly cover them below.
This narrative states that too many investors invested in value stocks. More people buying, directly or indirectly, pushes prices and valuations higher. As prices climb higher, expected returns become smaller.
However, we should have seen valuations of value companies approaching those of growth companies, not the opposite.
Technology is eating the world. You’ve probably come across that expression. This narrative suggests the technology revolution will reduce old businesses to irrelevance.
That said, no company stays at the top of their game forever. Furthermore, value companies are also revolutionizing their own businesses. Therefore, this alone can’t explain the underperformance.
Growth of Private Markets
Some defend that private equity firms buy undervalued stocks and take them out of public markets. This reduces the number of value opportunities out there and reduces their overall expected return.
Some stocks would fall into this category. However, we would likely see a price increase in those stocks before they become private, not cheaper.
Less Migration Between Value and Growth
Migration refers to companies being reclassified to value or growth, depending on their current situation. Some narratives suggest migration is slowing down. That’s because of the increase in monopolistic companies. Those monopolies prevent new companies from gaining market share.
If this narrative was correct, we should have seen fewer value stocks migrating than in the past, but the data doesn’t support that.
As mentioned above, we use the price-to-book ratio (P/B ratio) to find value stocks. That ratio doesn’t take into account intangibles such as research and development efforts.
As we move further into the services economy, intangibles are gaining importance. They enable companies to find new ways to generate cash flow.
Since the P/B ratio does not account for intangibles, companies might be misclassified. Some argue certain value stocks are being classified as growth because they have smaller assets on their balance sheets than they truly have.
If this is correct, we should see higher returns for valuation metrics that take into account intangibles.
Value Has Become Drastically Cheaper When Compared to Growth
According to this narrative, value stocks have become significantly cheaper compared to growth stocks.
If this is correct, the low valuation of value stocks vs. growth stocks will only be temporary. Unless something structurally has changed and the valuation gap continues to widen.
Is Value Investing Dead?
The popular narratives presented above offer some explanations for the lag of value stocks. For most of those narratives, the conclusion was clear:
We examine these explanations and find insufficient evidence to declare a structural break.Reports of Value’s Death May Be Greatly Exaggerated
But there is one that does explain it. Here is an excerpt from the study:
In the most recent 12-year period, the revaluation component appears to be the key to understanding why growth stocks outperformed value stocks.
That is, every time value stocks lag growth stocks by a meaningful margin, a key driver of the lag is value stocks becoming cheaper relative to growth stocks.
At the current valuation level, growth stocks trade at about 8 times the valuations of value stocks. The relative valuation has been wider only in two episodes over the 56-year history of our analysis: the peak of the dot-com bubble and the nadir of the global financial crisis.Reports of Value’s Death May Be Greatly Exaggerated
So the underperformance in value stocks is due to the over-performance of growth stocks. As growth stocks get more expensive, the valuation gap increases, making value stocks look cheaper.
Our evidence suggests that migration (e.g., individual value stocks becoming growth stocks) and profitability are not materially changed over the pre- and post-2007 periods. These two components are a net positive contributor to the value premium and we refer to them as structural alpha. The reason value has suffered a –39% drawdown is the collapse of relative valuations. Over the drawdown period, relative valuations have moved from the 22nd to the 97th percentile.Reports of Value’s Death May Be Greatly Exaggerated
More interestingly, the 2 past occasions where this happened preceded a huge market correction. So what is next for value stocks?
What’s Next for Value Investing?
According to the Financial Analyst Journal article, we’re about to see value investing rebound:
With today’s value vs. growth valuation gap at an extreme (the 97th percentile of historical relative valuations), the stage is set for potentially historic outperformance of value relative to growth over the coming decadeReports of Value’s Death May Be Greatly Exaggerated
However, there’s something to be aware of. Luck, good or bad, plays a role in investing. Even though the expected returns of value look favorable, there’s no guarantee that value will outperform growth in the short term.
But as a long-term investment strategy, value is still one of the best factors out there for investors to consider.
Value stocks seem very attractive, with valuations quite low compared to growth stocks. This, though, is no guarantee that value will outperform growth in the near future.
It will come down to when the valuation spread between value and growth stops widening. If that valuation spread narrows even slightly, we will see value stocks outperforming growth:
Even with a small mean reversion in relative valuations between growth and value, from 97th to the 95th percentile, value should outperform growth by 9% over the next year.Reports of Value’s Death May Be Greatly Exaggerated
In addition to that:
Even if valuations [were] to stay at the current levels the model would expect to see positive 5.1% premium.Reports of Value’s Death May Be Greatly Exaggerated
Historically speaking, on the other two occasions where we’ve seen this degree of underperformance, the market had a very large correction.
It’s hard to tell if we’re going to see a very large correction. That said, we’re likely going to see value strategies rebound in the future. That will likely mean a period of over-performance.
Even with the handful of large drawdowns over the 57-year sample period […], a value investor is still 4.8 times as wealthy as a growth investor.Reports of Value’s Death May Be Greatly Exaggerated
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A classic measure of value uses something called the price-to-book ratio (P/B ratio). A low P/B ratio means we’re looking at a potential value stock. A high P/B ratio means we’re probably looking at a growth stock.
The correct answer is: it depends. It depends on the timeframe, economic cycles and much more.
The primary driver of value’s underperformance post-2007 was growth stocks getting more expensive relative to value stocks.
No. There have been similar periods of underperformance in the past that led to a crisis followed by large periods of over-performance. Nothing structurally has changed in the market to support that claim.
As a long-term investment strategy, value is still one of the best factors out there for investors to consider.