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Where Has The 'Value' In Value Investing Gone?

| August 29, 2019

Over the long run, ‘value’ investing has a stellar track record, but since the global financial crisis value stocks have drastically underperformed growth stocks. The chart below shows the performance of the Russell 1000 Value Total Market index relative to the Russell 1000 Growth Total Market index over the past 10 years. Clearly, value has lagged during the decade long expansion.

Over this time, the Value index is up 11.5% versus a 15.3% rise in the Growth index. So, why the underperformance?

One reason that value has performed poorly on a relative basis is the tepid growth environment. Value stocks do best in very strong economic climates because a robust economy will tend to help weaker or distressed companies (that are part of the value universe) more than rapidly growing or financially stronger companies. If “a rising tide lifts all boats”, then the boats that are most likely to get left on the beach are those that benefit most from the higher tide. Unfortunately for value investors, over the past 10 years, there have been only 6 quarters in which annualized growth in the U.S. Gross Domestic Product (GDP) exceeded 3%. So, while the expansion has been long, it has been rather subdued. In an environment in which earnings growth is scarce, companies that have been able to deliver such growth have been more appealing for investors.

Another reason that investors have opted for growth stocks during the past decade relates to the low interest rates over this time period. One of the most important ways that interest rates effect asset prices (including stocks) is through their function as a discount rate. Investors value future cash flows that an asset may produce by using a discount rate to arrive at a present value for those cash flows. The impact of this discounting mechanism effects value stocks differently than growth stocks: value stocks normally pay more of their cash flows (either earnings or dividends) relatively soon whereas growth stocks are expected to have higher cash flows in the future (due to all that growth!). In financial terms, growth stocks are ‘higher duration’. As a result, they benefit more from the low interest rate environment that has prevailed over the past 10 years. Looked at in practical terms, waiting for future cash for many years isn’t so bad when interest rates are so low. This line of thinking makes growth stocks more attractive.

So, slow growth and low interest rates have likely predisposed investors toward growth stocks over the recent past. Will this continue? From the standpoint of economic factors, not much has changed: we continue to be in a slow growth, low interest rate environment. However, the trend in favor of growth has gone on for so long that value stocks are now priced at extreme discounts to their growth counterparts. Recent research from GMO noted that “relative multiples are now lower than in 90% of months since 1981.” So ‘value’ is even cheaper than usual.

Regardless of whether investors want to stick with growth stocks or switch to value, there are a few considerations to keep in mind:

  • “This time is NOT different!” Value investing has been around for hundreds of years. At some point, this cycle will likely run its course and value stocks will come back into favor.
  • Diversification across styles is not an all-or-none decision. Even if you believe that value investing won’t be making a comeback soon, a small allocation towards value stocks might be an acceptable solution.
  • Tilts towards growth or value (or their lack) can introduce additional portfolio risks. Investors should always monitor style tilts to make sure that portfolio exposures are well understood.