Growth stocks have outrun their value stock counterparts for years. Then, after a brief stint in the lead beginning late last year, value has fallen behind again.
Take heart, value investors: New research provides yet more evidence that value is a good bet to outperform growth in coming years.
Value stocks, of course, are those that are out of favor, trading for relatively low ratios of price to various measures of fundamental value, such as earnings, sales, and book value. Growth stocks, in contrast, trade for relatively high ratios, in anticipation that they will grow into those valuations.
Though the value category on average over the past century has outperformed growth, it has uncharacteristically lagged over the past 15 years. Beginning last fall, value began to reassert its historical dominance. But after a strong run of several months, in recent weeks it has begun to lag again. Many are wondering if that means value’s run is now over, or whether recent weeks are merely a pause on the way to a sustained period of strong relative performance over growth.
The new research that points to this latter prospect comes from AQR Capital Management. In a webinar last week, AQR founder Cliff Asness focused on whether fundamentals can explain the far greater valuations that investors currently are giving growth over value. His short answer: “No.”
To understand the significance of what AQR found, it’s helpful to recall that growth stocks’ earnings almost always are expected to grow more than value stocks’. That’s what makes them growth stocks, after all. The issue is how much more—and at what price.
Focusing on price first, it’s worth noting that value’s recent stretch of outperforming growth has barely put a dent in investors’ collective preference for growth stocks over value. Consider the average growth stock’s price/earnings ratio: According to Yardeni Research, the S&P 500 Growth index’s forward P/E ratio is currently 11.7 points higher than that of the S&P 500 Value index—nearly three times greater than the average differential over the past decade. Asness, in an email, said that “AQR, using different methods and different definitions of value, finds similar yawing price differentials.”
Focusing next on earnings, AQR’s research finds that analysts’ earnings forecasts don’t show a similarly big difference between growth and value. Analysts are projecting that the typical growth stock’s five-year earnings-per-share growth rate, relative to value’s, is pretty much the same today as the historical average. Specifically, Asness reports that from 1990 through 2017, growth stocks’ projected five-year EPS growth rates were 4.2 annualized percentage points higher than value stocks’, on average. As of June 30, this differential was 2.6 percentage points. (These averages were based on a weighted average of 2,000 global stocks.)
The point? Earnings forecasts can’t explain why growth is so historically expensive compared with value.
To be sure, earnings growth isn’t the only indicator one can use to differentiate growth and value. Some of those others look better for growth, and some worse. Overall, however, Asness found that they tell a similar story to the one when his firm simply focused on analysts’ earnings growth forecasts.
|Company / Ticker||Price/earnings ratio||Price/book ratio||Price/sales ratio||# of newsletters currently recommending for purchase|
|FedEx / FDX||14||2.9||0.9||4|
|Intel / INTC||11.9||2.6||3.1||4|
|Pfizer / PFE||11.1||3.0||3.2||4|
|Air Lease / AL||10.7||0.7||2.2||3|
|Berkshire Hathaway / BRKB||24.3||1.3||2.2||3|
|CVS Health / CVS||10.7||1.5||0.4||3|
|J.M. Smucker/ SJM||14.9||1.6||1.9||3|
|Leggett & Platt / LEG||17.8||4.3||1.3||3|
|Snap-On / SNA||16.6||2.9||3.0||3|
Note: Data as of July 20
Sources: Hulbert Ratings; FactSet
It’s in the resolution of this disconnect between the fundamentals, which are expected to remain consistent with the past, and the historically extreme price differential between value and growth stocks that Asness believes value to be “far more compelling than growth.”
You might still be impressed with AQR’s finding that growth stocks’ EPS are projected to grow 2.6 annualized percentage points faster than value stocks’, on average, over the next five years. But a higher earnings growth rate doesn’t necessarily translate into better stock-price performance. That’s because a stock’s return will be a function of how it performs relative to expectations. A growth stock’s EPS can grow and yet its stock still fall, if its EPS’ growth rate is lower than what the market currently expects.
Imagine a horse race in which you are allowed to bet on any of the 10 horses that are running. Let’s assume that the overwhelming favorite ends up coming in third, while the horse expected to come in a distant tenth finishes seventh. It’s not out of the question that you’d make more money if you had bet on the seventh-place finisher rather than on the one that came in third—even though it was still the far faster horse.
It’s worth emphasizing that, even though Asness believes value will outperform growth in the coming years, he advises that your equity portfolio be diversified and exposed to other factors in addition to value, including quality and momentum.
If you want to increase your exposure to value stocks, exchange-traded funds are probably the most convenient and least-expensive way to do so. For large-cap value stocks, one of the cheapest ETFs is the
Vanguard S&P 500 Value
ETF (ticker: VOOV), with an expense ratio of 0.10%. For small- and mid-cap value stocks, there is the
Vanguard Russell 2000 Value
ETF (VTWV), with an expense ratio of 0.15%.
For individual value stock ideas, I mined the Hulbert Financial Digest’s investment newsletter database for stocks that were highly recommended by top performers. Specifically, I started with all stocks that are recommended by at least three of the top-performing newsletters, and then eliminated any whose P/E ratio, price/book ratio, and price/sales ratio weren’t below those of the S&P 500.
The 10 stocks that survived this winnowing process are listed above, in descending order of the number of purchase recommendations each is currently receiving.
Mark Hulbert is a regular contributor to Barron’s. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]
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