Between 1927 and 2007, value investing dominated as a long-term recipe for steady investment returns. Emerging from the Great Recession, the tables have turned and growth investing has outperformed fairly consistently since. From 2007 to 2020, value returns lagged growth by a cumulative 40%. And now in the wake of the Coronavirus pandemic, the gap between growth and value has exploded to its widest divergence in decades.
As of Monday, the broad large-cap Russell 1000 Growth index is up by 14% for the year to date, while the Russell 1000 Value index is down by the same amount, 14%. This massive 28 percentage point chasm is so anomalous that many analysts are predicting that a reboot is in the offing. As economist Herbert Stein quipped: "If something cannot go on forever, it won't."
Value investors haunt the yard sales looking for bargains. By analyzing fundamental financial data like the PE ratio and price-to-book value, they seek to identify stocks of companies trading well below their estimate of intrinsic or "fair" value, and then wait for the price to catch up. Growth investors are more likely to pay full price or even a premium on the assumption that the upward momentum will continue and that earnings will eventually follow. Both styles posit pricing errors, but view them in very different ways.
One major contributor to the outperformance of growth stocks has been a long period of historically low interest rates. Analysts' models of stock valuations incorporate some variation of discounted cash flows; that is, estimating future profits and "discounting" or estimating the present value of those future flows. Since the denominator contains the prevailing interest rate, a stock's present value depends directly on the general level of rates. The lower the rate, the higher the present value. This effect is more pronounced with growth stocks, which by definition are projected (rightly or wrongly) to increase cash flows faster in the future. With U.S. interest rates at all-time lows, the gap between growth and value stock valuations has consistently widened.
In addition, while the stretch between 2009 and 2020 encompassed the longest economic expansion in history, it was also the weakest. Annual GDP growth averaged 2.3% per year during this period, compared with 3.6% per year for the 1990s expansion. Value stocks perform better during strong growth spurts coming out of recessions. A more anemic recovery has favored stocks that offer at least the hope for faster sales and earnings growth.
Of course, popular sentiment also plays a role. One might recall the dot-com bubble of the late 90s, the last comparable period of divergence between growth and value. During that remarkable episode, valuations were even more stretched than today, with thousands of money-losing companies trading at ridiculous prices. The reckoning arrived in March of 2000, with a 65% decline in the NASDAQ index that only fully recovered 15 years later.
To be sure, growth stock valuations based on earnings are still below 1999 territory, but they are currently higher than at any other time in the postwar period outside the dotcom mania. And the variance between growth and value has never been wider.
Unless one believes the laws of gravity have been repealed, the market will ultimately cycle back toward a focus on fundamental valuations. Given the extreme levels and weak economic outlook, Goldman Sachs predicts an average annual stock market return of about 5-6% over the next 10 years. But within that relatively modest expectation, a long-awaited rotation out of high-priced growth into low-priced value could present an opportunity for investors to outperform the overall index.
Last week, value investors were somewhat heartened to see a slight swing back in their direction, as value stocks outperformed growth by about 3 percentage point, but there have been many head fakes over the past decade. Still, playing the odds, a long-term investor should consider increasing their allocation to the cheaper value side of the house to reap the reward from the eventual swing of the pendulum. Assuming that Isaac Newton was right.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga