Value vs. Growth? How about Fundamental Research

In 1992, economists Eugene Fama, Ph.D. and Kenneth French, Ph.D., published their seminal paper arguing that value stocks tend to outperform growth over the long term, and small-cap equities outperform large-cap. But in recent years, investors who have followed these principles – whether by building their own portfolios or taking advantage of smart-beta funds that invest based on factors, such as market capitalization and valuation – were likely disappointed. For the five years through January 31, the Russell 1000 ^® Growth Index, a benchmark of large, fast-growing companies, returned 17.9% annualized. Meanwhile, the Russell 2000 ^® Value Index, a benchmark of small companies with lower price-to-book ratios, returned only 12.0% and experienced more volatility, as measured by the standard deviation.

Russell 1000® Growth Index – Russell 2000® Value Index
Value and small-cap stocks have underperformed their large-cap growth peers since the Global Financial Crisis.

These anomalies – where growth outperforms value for many years – occur. But in the past, outperformance often was driven, in part, by rapid multiple expansion. That is not the case today. Although valuations have climbed, they do not appear bubbly. As of January 31, the 12-month forward P/E for the Russell 1000 Growth was 21. While higher than the long-term median of 18, the multiple is still well below levels seen during the tech bubble, when the forward P/E got as high as 37.

Could growth continue to outperform for a while longer?

This Time may be Different

Making this type of market call is a fool’s errand. But looking across the economy, it is reasonable to argue that fundamentals have shifted in the more than 25 years since Dr. Fama and Dr. French published their research. The rapid pace of digital innovation – from the ubiquity of the Internet and mobile technology to the power of machine learning – is disrupting business models across industries. Just consider: At its peak, Walmart accounted for roughly 10% of all U.S. retail sales (excluding autos and food), a feat that took some 40 years to achieve. Amazon.com, in contrast, now claims approximately 40% of the digital equivalent, while continuing to encroach on the sales of competitors, including small-cap firms. What’s more, the e-commerce titan achieved this market share in about half the time as Walmart. In other words, technology is helping companies scale their businesses in ways rarely seen before.

Growth for these mega firms remains impressive, too. Amazon’s profits are expected to rise 34% in 2018, according to consensus estimates. Similarly, Facebook’s earnings are projected to jump by an equal amount for the same period, while Alphabet (the parent company of Google) could see profits more than double. This is notable: Historically, large established companies have been the slow growers in the market.

Markets are Dynamic

Investment tools have also changed. Smart-beta exchange-traded funds (ETFs) are designed to track indices weighted toward specific factors. Such ETFs have attracted capital flows lately and may, as a result, help dull the advantages of the asset class. (One of the surest laws of markets is that when inefficiencies are discovered, it tends to get competed away.) Even worse, these indices could be made up of firms that boast low valuations for a reason: For example, their business models are outdated; they are at risk of profit margin compression; or they have management teams ill-equipped to adapt to new competitive landscapes. In a period where innovation is driving rapid economic changes, these risks become more acute for firms – and investors.

Fundamental Research is Key

This is not to say growth will always outperform value. Even Dr. Fama and Dr. French acknowledged that markets experience value-growth swings. What’s more, history shows that value has tended to excel in the late stages of a business cycle (such as today). That’s because as interest rates rise on the back of a strong economy, growth companies – whose cash flows tend to be realized farther out in the future – are more acutely impacted by higher discount rates.

So, there’s certainly an argument for owning value stocks. The difference now is making sure you own value for the right reasons. In my experience, one way to position yourself for sustainable outperformance as an investor is to do the hard work of fundamental research. With so much upheaval in the economy, it’s important to focus on what hasn’t changed: the age-old rules of what makes a good investment. Rigorously applying those rules, day after day, is what counts, no matter which segment of the market – growth or value – rules the day.

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Growth and value investing each have their own unique risks and potential for rewards, and may not be suitable for all investors. A growth investing strategy typically carries a higher risk of loss and a higher potential for reward than a value investing strategy. A growth investing strategy emphasizes capital appreciation; a value investing strategy emphasizes investments in companies believed to be undervalued.

Smaller capitalization securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalization securities.

Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.

Beta measures the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.

Standard Deviation measures historical volatility. Higher standard deviation implies greater volatility.

Enhanced Beta or Smart Beta refers to a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices.

Russell 1000 ^® Growth Index reflects the performance of U.S. large-cap equities with higher price-to-book ratios and higher forecasted growth values.

Russell 2000 ^® Value Index reflects the performance of U.S. small-cap equities with lower price-to-book ratios and lower forecasted growth values.