Why You Should Allocate to Value over Growth
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We recently saw an analysis from StarCapital that provided context for how the market over the last several years resembles the late 1990s and other periods when value strategies underperformed.
As we found their thesis to be compelling, we did our own analysis using the same source data to better understand and expand on their results.
The chart above plots the trailing five-year annualized return of a hypothetical portfolio (the value versus growth portfolio) that goes up when value stocks are outperforming growth stocks and down when growth is outperforming value. The returns of this portfolio were constructed using data that can be found at Kenneth R. French’s website, where a value stock is defined as one having high book equity to market price. In this case, we are looking at the relative performance of the 20% least expensive (value) companies in relation to the 20% most expensive (growth) companies. All returns are compounded monthly.
The chart shows that value outperformed growth across most five-year periods and did so by roughly 5% annualized over time. This value premium has been observed and commented on by many investors and researchers. But, why does it persist over time? Value stocks are inexpensive in relation to things that are known about a company, like their earnings or book value. Growth stocks are expensive because investors expect those same things (earnings, book value, etc.) to quickly grow. We believe investors are not good at predicting the future, and they are prone to extrapolating recent results too far. Thus, value stocks – as they often are working through some form of hard times – may become over discounted. Likewise growth stocks – as they often have posted strong recent results – may have prices that reflect unrealistic future expectations. We believe this is a major reason that inexpensive stocks outperform expensive stocks over time.
Even so, it is obvious that value stocks do not always outperform. In fact, since World War II, there have been six distinct periods when growth outperformed value on a trailing five-year compounded return basis. We are currently in one of these periods; the last time this happened was during the dot-com era.
As shown in the above chart, during the previous five periods when growth outperformed value, value subsequently delivered very strong results over the next five-plus years. In the current cycle, the value rebound has not yet occurred. Why? Will such a rebound eventually occur?