A perspective from E*TRADE Capital Management, LLC
In politics, there’s left or right. With smartphones, it’s iOS or Android. While there are more than two choices in each scenario, the major players dominate the landscape. Such is the case with equity investing. Investors have many different asset classes to choose from, but the playing field is often delineated in terms of growth or value.
Since the post-crisis economic recovery began in late 2009, the results have been lopsided, to say the least. In fact, growth stocks have outperformed value stocks for so long that some may question the viability of value strategies altogether. But there are signs that the tide could finally be turning.
First, what do we mean by growth and value?
Growth versus value: It’s all about investor sentiment
Deciphering between growth and value can be highly subjective. Often the distinction boils down to investor sentiment and, by extension, valuations. But there are a number of hallmarks to look for:
A value stock is viewed as underpriced based on company fundamentals. That is to say, value shares are priced below their “intrinsic value.” Although a company’s earnings and growth prospects might be sound, the stock still trades at low price-to-book (P/B) or price-to-earnings (P/E) multiples. Investors acquire value stocks under the premise that they will pay steady dividends or eventually close the gap between their market price and intrinsic value.
In baseball terms, a value stock is a solid middle infielder with a decent glove. Sure, the guy doesn’t have much power, but he won’t demand a king’s ransom and can be counted on to make the routine plays year after year. A value stock could also be a diamond in the rough. David Ortiz was a value stock in 2003. There was a glimmer of potential. But with a .266 career average and questionable defense, he was released and passed over by 28 teams before the Boston Red Sox picked him up at a bargain price.
A growth stock is just the opposite. Expected to perform from the get-go, growth stocks are issued by fast-growing companies—most recently in the information technology sector. Growth stocks seldom pay dividends, but they have significant growth potential. They can also be risky and prone to volatility. Mark McGwire was a classic growth stock—a brawny slugger who lived up to the hype until it was discovered that he cooked the books.
As for David Ortiz, by 2005, the below-the-radar value stock had morphed into the legendary Big Papi—a growth stock who eventually amassed 10 All Star appearances, three World Series titles, and more than 540 career home runs.
Which brings up another point: Value stocks can metamorphose into growth stocks. Apple in 1997 was a value stock; Apple in 2017 was the very definition of a growth stock.
Are certain sectors oriented toward growth or value?
Whether a stock is considered growth or value largely depends on investor sentiment. Energy—which has historically rotated between growth and value—is currently one of the three largest sectors within the Russell 1000® Value Index, while consumer staples—a traditional value sector—doesn’t crack the top five.
Likewise, large technology stocks occasionally make their way into value indexes, while health care is a top-three sector in both the Russell 1000 Value and Russell 1000 Growth indexes. As projected growth rates and valuations change, these sector weightings can also be expected to change.
Growth stocks: A decade of outperformance
Because classifying growth and value can be subjective, we’re left to use benchmark indexes as barometers of performance. By this measure, both growth and value stocks have posted solid returns over the past decade, but growth has been the star performer. Since August 2008, the Russell 1000 Growth Index has generated an annualized total return of 12.37%, while the Russell 1000 Value Index has returned 8.95%.1
Source: FactSet, July 31, 2018
But value’s time could be coming. On one hand, value stocks are generally sensitive to economic cycles, which could be problematic if the economy slows. On the other hand, value stocks can outperform in a “risk-off” environment in which there is a flight to quality and greater emphasis on individual stock selection. Notably, value stocks have historically exhibited meaningfully lower risk than growth stocks in the form of standard deviation.
Potential catalysts for value stocks
• Valuations. Because they’ve been out of favor for so long, many value stocks are trading at levels that could make for a compelling entry point for opportunistic investors.
• Sector fundamentals. Conditions could be favorable for sectors that comprise the largest weightings in value-oriented indexes—namely energy, health care, and financials. Rising health care spending, increased energy demand coupled with crude oil supply constraints, and rising interest rates could bode well for these three sectors.
• Aging bull market. Growth stocks have benefited from a growing economy, a nine-year bull run, and a significant run-up in technology share prices. With economic growth prospects moderating, growth stocks could be due for a correction.
• Rising interest rates. During the last period of sustained interest rate increases, from 2002 to 2006, value outperformed growth for 15 consecutive quarters.2 With interest rates on the rise once again, could history repeat itself?
Beware value traps
One last note about value stocks: Beware value traps where possible. Value traps occur when a stock appears cheap but has been trading at low multiples for an extended period. In these cases, the stock price could move even lower if a deteriorating balance sheet or potential bankruptcy comes to light.
One way to overcome value traps is to dive deeper into a company’s financials. Solid fundamentals and some level of upward price momentum could increase the prospects of a stock moving closer to its intrinsic value.
Consider growth and value for added diversification
Also bear in mind that this is not an either/or scenario. A diversified portfolio should ideally include a mix of growth and value holdings, which can help investors participate in market gains while providing some measure of downside protection.
Value has taken some punches to the gut, but it’s still on its feet. Depending on your time horizon, this fight is likely far from over.
1. FactSet, August 15, 2018.
2. MarketWatch, “This may be the best time for value over growth stocks in 17 years,” April 3, 2018. https://www.marketwatch.com/story/value-stocks-may-break-out-helped-by-rising-interest-rates-inflation-potential-trade-war-2018-04-03
The Russell 1000 trademark is owned by the Frank Russell Company.
E*TRADE and the Frank Russell Company are separate and unaffiliated companies.