Value stocks vs growth stocks

One of the common dilemmas confronting equity investors at various points has been the choice between value and growth stocks; never more so than at present as the world of the market over have raced away, riding the optimism of expected economic recovery and vaccines becoming a reality.

So, what are value and growth stocks really? Value stocks may commonly be perceived as low-priced bargains. As the name suggests, relative undervaluation is a typical trait of such stocks. This is usually on account of the low earnings growth projected in the future. By extension, such companies may not typically be reinvesting earnings for the future and may tend to exhibit higher dividend payout ratios.  Think of growth stocks as the opposite – higher earnings growth projections may lead to market participants willing to pay higher valuations to participate in such companies looking to reinvest more internally to fund future growth. 

Of course, this conceptual generalization does not address the issue of some grey area that will always remain when slotting stocks as value or growth; stocks may transition in and out of one category numerous times during its life cycle. Some stocks may strongly exhibit a solitary trait and yet others might have mixed traits of both. The stock universe is quite diverse in terms of companies’ earnings profiles, liquidity, leverage, cash flows, growth rates, revenues, and other metrics and there will always be considerable subjectivity. 

With that context, it may be noted that indices and funds representing growth stocks have remarkably outperformed value in the recent past. Below is the performance summary for two prominent ETFs in existence since 2000 and tracking S&P 500 Growth and Value indices:

Source: Morningstar Direct

As can be seen in the chart, growth has outperformed value in the last decade, but the outperformance in the last 1-3 years has been far more dramatic driven by frenzy for new generation technology stocks. The value space by itself appears to have performed reasonably well over the last decade but completes pales in comparison to growth. 

So, what could be implications for investors at this stage when considering value space? Should one ignore it altogether and continue to skew towards growth? Or should one totally rotate out of growth in anticipation of a reversal? The optimum approach would be to follow a middle path. For portfolios that are heavily skewed towards growth there is a case to consider value as part of the portfolio, notwithstanding the past performance as highlighted above.

While it is difficult to call if growth stocks have run their course, the current stretched valuation is something to be kept in mind. The valuation gap between the two has widened dramatically over the last decade as shown below:

Source: Morningstar Direct

The gap is much more than it has been at any point in the last 2 decades, and apprehensions of a ‘mean reversal’ would be understandable. Value stocks doing better in the future could be one way to pull this gap back to earlier levels. In that regard, performance over the last 3-6 months may be worth noting, in that, not only has value participated in the equity markets recovery, but it has also outperformed growth in the last 3 months as shown in the chart below:

Source: Morningstar Direct

While it may not be sufficient to conclude a trend reversal, it may point to a revival of interest in the value space and more broad-based participation than only growth-led. 

Comparisons of the current technology-led growth with the tech mania of the late ’90s and the dot com bubble burst are being had been made for some time now, though it may well be argued that the profitable nature of most of the top-line technology companies today is vastly different from those of the earlier era.  Yet, it may be interesting to note that post the famous bursting of the tech bubble, the 5-year period up to 2005 saw value outperforms growth, though by a much lesser margin:

Source: Morningstar Direct

Another factor to consider is that while there is expectation of revival of economic growth globally in the years ahead, any unanticipated event risks or near-term shocks playing out might hit the growth stocks far more than others.

Another, one further thing to watch out for is bond yields. In the last few months, yields have plunged in the wake of central bank stimulus in the aftermath of COVID. That had further contributed to price spikes in technology stocks that dominate the growth space. Valuations of technology stock are extremely sensitive to interest rate assumptions. Their earnings are typically projected much longer into future and discounting those at much lower yields also contributed to expanding their valuations. However, in the event of bond yields rising, the reversal could also be severe. Recent data indicates yield curve steepening in US economy (long term bond yields increasing). That is usually considered as a sign of economic growth which would further augur well for cyclical sectors like financials and energy that currently comprise the value space. 

While there is merit in considering exposure to value space, one also needs to bear in mind that there is no substitute for bottom-up stock picking based on company specific fundamentals. Further, every equity cycle is unique in and can throw up new trends; parallels with past trends may not always be useful. Understanding one’s own investment style combined with diligent research is crucial in equity investing. Lastly, in the unprecedented times that we are in where several ‘new normal’ may have been established, portfolio discipline is the investor’s best friend. One should not lose sight of the basic tenets of portfolio planning.  Remaining focused on their overall investment goals, asset allocation structure and maintaining an appropriate diversification across assets and geographies, and by extension equity styles also, is crucial. 

A version of this article was published on Financial Express.