Countering the Narrative About Value

There have recently been a slew of articles about how value investing has lost its edge.  Some have argued that the value premium has been arbitraged away by investors, while a few have claimed that perhaps a new era has arrived during which growth investing will be in favor.

The reality, in my opinion, is that none of this is true.  As I have written elsewhere, the value “premium,” by which I refer to value’s historical excess performance versus growth,  has been more or less nonexistent in large cap stocks, and is to be found generally in small and mid-sized companies.  One way to visualize this is to see the disparity in performance for the respective value and growth Russell indices for small cap stocks (the Russell 2000 index), and for large cap stocks (the Russell 1000 index).  Over the last ~40 years, small value stocks have earned more than 3% a year more than their small growth counterparts, while in the large cap universe, the advantage for value has been about 80 basis points annually:


Furthermore, while the Russell Growth and Value indices are useful for generalizations about growth and value, the large cap indices should not be cited alone as evidence of value’s lost luster when little attention is paid to their methodology, which has led to significant imbalances across sectors.  By using the price-to-book ratio (or “P/B”) as a primary determinant of value, the Russell 1000 Value index has tended to favor stocks from sectors with generally low P/B ratios, such as financials and energy companies, while excluding stocks from sectors such as technology and consumer staples, which may look cheap relative to earnings or cash flows, but have lofty P/B ratios.  This, combined with a lack of sector constraints, means that comparing Russell 1000 Value to Russell 1000 Growth is really more akin to comparing energy and banks to consumer and technology stocks:


The impact of these sector imbalances is not trivial.  After all, for the first twenty or so years of the Russell Value and Growth indices, the relative performance of value over growth was slight but consistent until the peak of the tech bubble when growth pulled ahead temporarily.  However, more importantly, for value investors, the ensuing six or seven years was a period of unprecedented outperformance, not just because the tech collapse harmed growth, but primarily because the heavyweights in value, – energy and financials, – were in simultaneous supercycles, which of course culminated in the collapse from 2007-2009 (relative cumulative returns):


This can perhaps best be seen by looking at how the sector-specific indices (categorized into growth and value camps) for energy and information technology performed annually during this “value boom”:


As can be seen, during the period which saw oil soar to $147 per barrel, energy stocks of both varieties did very well, while both ‘cheap’ and ‘expensive’ tech stocks did mediocre.  The difference, of course, is that the overall value index had far more exposure to energy, while growth had too much exposure to tech, thus distorting the perception of overall  performance for growth and value.

Similarly, the reverse has happened over the last ten years, when technology earnings have grown steadily, while energy stocks find themselves in the wake of second bust in the last decade (CAGR):


Again, the cycle had nothing to do with cheap versus expensive, but rather which sector was growing and which was in decline (earnings per share growth, via Yardeni):


In reality, in the large cap space, there is little variation between growth and value at the sector level for sectors that are in secular growth mode, such as health care, consumer staples, and technology.  Conversely, in some very highly cyclical industries such as energy, value may prevail over the long run, given that growth in the energy space is typically associated with smaller firms that do well when energy is peaking, but suffer the consequences when oil prices retreat.

It would be helpful, in my opinion, to create better ways to measure value and growth, such as on a sector equal-weighted basis, or on a sector-neutral basis, as MSCI is starting to do.  This would give investors better tools for their portfolios by reducing to a large extent unintended large sector bets.  However, for now, investors should “look under the hood” of their investments in order to understand what exactly it is their value and growth portfolios own, and they should be careful not to act too hastily on the pronouncements of talking heads who neglect to dig sufficiently deep into a topic before passing judgment on an investment strategy.