Why has value investing underperformed growth investing for over twelve years and how to position your portfolio for the eventual rebound in value investing.
In this episode you’ll learn:
- The difference between growth and value investing and why value investing outperforms growth investing over the long-term.
- How value and growth indices are constructed and how they differ from fundamental indexing.
- What are the risks and opportunities of investing in concentrated, deep-value managers.
- Why value investing will eventually rebound and how to participate.
Value investing is the concept that buying stocks at a price lower than their intrinsic value will provide a good return—based upon the future value of that stock’s cash flow. Historically, value investing has proven to outperform growth investing—buying stocks with high earnings growth potential. In the past 12 ½ years, however, the opposite has occurred. Growth investments have consistently outperformed value investments. In this episode, David explains what drives both value and growth investments and why value investing should still earn a place in investors’ portfolios.
Weighting a portfolio towards value or growth investments
Investing in value and growth stocks is somewhat of a speculation because no one knows exactly what the intrinsic value of a stock is, yet that is what managers and index funds are basing their indices on. To hopefully ensure a good return, managers and index funds overweight certain portions of their allocations to areas in the market they believe are undervalued. Value managers typically overweight in financials and utilities, while growth managers tend to overweight in technology options. Managers of both value and growth assume that the growth rate of the stock will outperform the current cash-flow. Generally, growth investments have a faster growth rate but are not as sustainable long-term. Value investments have a much slower growth rate but prove to be more steady in their long-term yield.
The past twelve years have not gone according to the historical trend. Value investments have underperformed, and growth investments have done extremely well. Value managers tend to be pessimistic towards growth investments because they are unwilling to put down a lot of money initially in the hopes that the stock will do well in a short period of time. Having a value tilt to your portfolio usually performs much better than having a growth tilt, but growth investments have done extremely well in recent years. And value stocks have become more sparse in their accessibility.
Reasons for the poor recent performance of value stocks
David explores other times in history that the value stock has underperformed for such a long stint. 1926-1941 was also a time of heavy underperformance by the value stock compared to the growth stock. The reasoning could lie in the domination of each stock by specific sectors. During the 1926-1941 timeframe, the S&P 500 growth index was made up of 65% manufacturing stocks, while the value index was made up of only 19% manufacturing. 74% of the value index consisted of utility stocks. The same high level of favoritism towards a certain sector in the value and growth indexes is occurring today. The Russell 1000 growth index is weighted by 38% in technology and 3% in financials, while the Russell 1000 value index consists of 6% in technology and 24% in financials. As we have seen in recent years, technology has done incredibly well. The drawback is that it is expensive, and managers don’t know when the tide might turn in favor of value investments.
Why are the growth and value indexes so grossly weighted towards certain sectors? Indices are constructed differently, yielding different results. Capitalization index calculation looks at the whole of the investing universe and organizes stocks according to characteristic and size. To be considered a growth stock, it must have future long-term growth in earnings per share, future short-term growth in earnings per share, three years in historical growth in earnings per share, three years in historical growth in sales per share, a current investment to asset ratio, and return on assets. When determining if a stock is a value stock, this method considers the future earning- to-price ratio, historical earnings-to-price ratio, dividends-to-price ratio, and the sales-to-price ratio. With the above calculation method, value stocks turn out to be the cheapest stocks with slower growth rates, while growth stocks are more expensive and have higher growth rates.
Fundamental indexing takes a slightly different approach to determining what makes a value or growth stock. Instead of weighting the index based upon size, fundamental indexing weights based upon metrics such as revenue, earnings, and dividend yields. This type of indexing considers the market to be inefficient and is a bit more skeptical when it comes to companies that are overvalued. Sometimes the biggest names in an index are too expensive. Both capitalization and fundamental indexing result in biased indices, however.
Why underperforming managers are sometimes worth allocating with
Value managers have been underperforming for the past several years. But does that mean we should not use them? While growth managers have had excellent success for the past 12 years, there is no way of knowing how long the big names in the indices will stay there. Knowing when the tide will turn in favor of value again is difficult, but it could happen at any time. Allocating to a value manager—even if they are currently underperforming—could prove to be highly beneficial to your portfolio when the growth rate for growth investments slows down. Value managers know that the big technology companies that lead the growth management sector are not infallible. Sometimes, an economy that is doing very well is an economy to be wary of. Change can come at any moment. Short-term growth investments can be very beneficial to a portfolio but the cheaper, long-term value investments shouldn’t be ignored—and neither should the value manager. Just because a value manager is underperforming now doesn’t mean he or she isn’t skilled. It could simply be that their strategies are out of favor.
Value investing may be underperforming, but it isn’t dead
David shares that he doesn’t believe value is dead. Most of his value allocation is through fundamental indexing methods. Things will not always remain the same as they are today. People make mistakes and can put too much emphasis and trust in currently booming companies and stocks. But today’s success doesn’t always equal tomorrow’s success. Keeping your portfolio diverse by allocating to both growth and value indices may prove to be beneficial to the future health of your portfolio.
- [0:18] What is value investing?
- [2:07] A historical look at growth vs. value yields.
- [5:41] The return of the value stock in the early 2000s.
- [11:07] The twelve and a half years of underperforming value stocks.
- [13:09] The sectors controlling the performance of value and growth stocks.
- [15:01] Better understanding the indices.
- [20:31] Using fundamentally weighted indices to balance your portfolio.
- [23:10] Are underperforming managers struggling because of poor skills or because of unfavored strategies?
- [29:20] While value may be difficult to predict, it isn’t dead.
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