The Convergence of Value and Growth
Value stocks have not kept up with growth stocks for more than a decade. Most value investors regardless of their investment orientation, fundamental or quantitative, have been swimming against the current arguing that value investing is not dead, but has just been out of favor. Closely associated contrarian investing has lost its luster as well. There is something contrarian about value investing in that as a firm’s valuation metrics, such as its PE ratio, decline, it gets more and more attractive to a value investor (with the exception of “value traps,” where an extremely low valuation is a product of deterioration in the business fundamentals and results in the eventual demise of the company). Both fundamental and quantitative investors argue that the spread between value and growth stocks is at all-time highs. Depending on the reference frame either the growth stocks are overhyped, or the value stocks lag, but which one?
Value stocks have not consistently exhibited better downside protection either, and they disappointed investors during the pandemic-related sell-off in the first quarter of 2020. What worked in the first quarter of 2020 was the opposite of value. If you promised growth, like a biotech company, with no real cash flows, you did great, because there was nothing there quantitatively measurable that could decline 95% due to the pandemic.
Over the past 15 years, value indices have painted a depressing picture, except for the past few weeks. For example, the Russell 3000 Value Index, a bellwether for all-cap value stocks in the US, lagged its growth counterpart by more than 5 percentage points. That same discrepancy doubles to more than 10% over the past five years, and it reached nearly 18% underperformance for the trailing three years ending in July 2020. The numbers are staggering by any measure. The only silver lining is the recent uptick in value stocks. For example, since August 1st, for the 12-day period, the Russell 3000 Value Index is leading the charge by about two percentage points, and small cap value stocks follow suit with a more aggressive nearly four percentage point run ahead of small growth, indicated by the Russell 2000 indices.
Aside from a pure comparison of the value and growth discrepancy, the impact of value has been dislocating blend and growth categories because the funds that lean more heavily on the growth side of a core/blend category, for example, have consistently performed better than the ones that lean more on the value side of the spectrum. The persistence of that trend has given lots of headaches to disciplined, well-resourced value managers who have not budged and stayed the course. The more disciplined a manager, the more value-focused the investment process, the more it lagged its peers. Further, it has been a challenging job to keep broadly available mutual fund categories in line with their corresponding indices. Many Russell indices, especially in the small and mid-cap space, have been on a “growthier” trend, meaning blend indices look more and more like growth indices. That is certainly a challenge for managers to maintain their style purity.
There are two factors that may be impacting the value and growth discrepancy in the time periods analyzed above: structural winds in business cycles and interest rates. Structurally, the question is: has the world changed so much that the widget-makers are no longer sustainable businesses? Have energy and consumer staples companies run their course and will never exhibit earnings growth again? Is it now all about the FANGs and other technology firms that can be run on online platforms, with remote workers globally? Will Amazon make the next toothpaste, and Colgate and Crest are no longer needed? Not likely, given the firms’ competitive advantages. In addition, technology is not just about technology companies. Technology can be applied across the board on any business area to improve efficiencies.
A painful, prolonged decline in the commodity and energy prices certainly hurt the energy, materials and industrials sectors, and a flat/compressed yield curve did not bode well for financials ̶ the usual suspects of value investing. The effect of interest rates is particularly important. The yield curve determines what the cost of capital is for all companies. If a growth company is not generating free cash flow but exhibits rapid top-line growth, that company’s valuation when projected out 10 or 20 years will benefit from a flat yield curve and low interest rates much more than a value company with plenty of cash on the balance sheet and lower growth. Conversely, companies with low valuations show relative strength when the economy exits a contractionary period during an early recovery phase. The Fed’s signaling of higher rates gives away that regime change. This also marks the periods in favor of value stocks historically.
Yes, the spread between value and growth stocks are at all-time highs. However, if we go back to the technology bubble and look at the performance differential since March 2000 through July 2020, what we find is that the growth stocks have just caught up with the value stocks; almost there, but not quite. The reason for that was the burst of the technology bubble, which led to a 23% underperformance by growth stocks. So, one could argue that value has persistently underperformed, or depending on the time period analyzed, one could also argue that it is not just that value is out of favor, but growth may be overheating again. The market has reached all-time highs at the time of this writing, but there is no guarantee that the market has overcome the pandemic-inflicted damage yet. We probably have some ways to go before we declare that things are back to normal and the market has simply left value stocks in the dust.