The Case for Value

The past ten years has been a tough period of time for proponents of value investing. Since June 30, 2008, the Russell 1000 Growth Index has returned 11.8% versus 8.5% for the Russell 1000 Value Index. The poor performance of banking and energy companies (which are mostly categorized as “Value”) combined with the great performance of technology and healthcare companies (mostly “Growth”) were the primary factors contributing to this difference in returns. Over the past ten years, financial stocks, on average, appreciated by only 5.2% per year and energy stocks appreciated by only 1.2% per year. On the opposite end of the spectrum, technology and healthcare stocks grew by 13.1% and 12.1%, respectively.

 

Therefore, one might be thinking, “What is a value stock and why should I care, especially in light of recent performance?”

 

Investment professionals tend to separate stocks into two primary buckets—value and growth. A value stock is one that tends to trade at a lower price relative to its fundamentals (e.g., things that can be measured like sales and profits). Common characteristics include an above-average dividend yield, low price-to-earnings, and low price-to-book. Value investors believe that investing in value stocks is a less risky way to earn a fair return since the company doesn’t have to do anything extraordinary to be a good investment. In other words, on average, the upside potential is greater than the downside risk.

 

A growth stock, on the other hand, is a company that is growing sales (and, hopefully, profits) at a faster rate than the average company. A growth stock tends to trade at a higher price relative to its fundamentals. Common characteristics include above-average price/earnings and price/book ratios. Also, many of these companies pay no dividend, preferring to invest all profits back into the business. Growth investors believe that future earnings will be significantly greater than current earnings. In other words, they need their companies to continue to grow at a high rate for an extended period of time—something that is not easy to do.

 

Both value and growth stocks will increase in price during good times. Both will decrease in value during bad times. The big difference between the two styles is that growth stocks are more susceptible to large and sudden decreases in stock price due to the significant expectations that are sometimes put upon them (think Pets.com, or more recently, the Bitcoin-related companies).

 

Despite the past ten years, which happens to be the longest “slump” ever for value vs. growth, we believe there is a strong case for sticking with value and maintaining a diversified portfolio (which includes both growth and value stocks). Since 1926, there have only been three periods of time when growth outperformed value for any significant length of time:

1) 1933 – 1940

2) 1994 – 2000

3) 2007 – present.

And more importantly, over the past 90 years, value has outperformed growth by more than three percentage points per year, on average.

 

Going back to the topic of risk, the U.S. stock market is now trading at valuation levels similar to where stocks were trading in 1996, and above the valuation levels reached prior to the 2008 financial crisis (according to the Case-Shiller CAPE). Historically, this is rare territory for the stock market. It has also been rare for stocks to remain in a bull market for this length of time (over 100 months). This doesn’t necessarily bode well for either growth or value stocks, but it could mean that during the next economic slump, growth stocks will decline more than value stocks.

 

Another point on the side of value is that rising interest rates ultimately act as a tailwind for value because of the high percentage of financial stocks that reside in this category. When rates are rising, banks increase loan rates faster than they increase deposit rates and this tends to increase their profitability.

 

A third point for value is that dividends offer a hedge against inflation. One of the results of tariffs is higher prices for the consumer (i.e., inflation). In the past, during periods of above-average inflation, dividend growth has accelerated. Since value stocks tend to pay higher dividends, value investors may do better than growth investors in this type of environment. As an added bonus, dividend paying stocks tend to exhibit lower levels of volatility of returns over the long term.

 

In summary, value has outperformed growth over long periods of time. Based on valuations, the odds favor value over growth at this time. A rising interest rate environment can be positive for financial stocks as profit margins increase. Lastly, trade and tariff pressures could lead to inflation, which further bolsters the case for dividends (and value stocks, in particular).