Whenever the topic of portfolio design is discussed, you can be sure that the issue of value investing versus growth investing will come up. It is an issue when considering how to invest in U.S. stock mutual funds and non-U.S. stock mutual funds.
The term value suggests that the investor is buying stock that is relatively less expensive, as opposed to stock that is relatively more expensive. The stock of a company that is classified as a “value stock” typically has a lower price-to-earnings ratio, which simply means that the stock currently has a lower price per share relative to the company’s earnings per share. Think of it as investing in the home that needs repair versus putting more money down for the glitzy house on the hill. Very simply, value stocks are priced more attractively. The real question is whether or not value stocks tend to outperform growth stocks.
Growth stocks are just the opposite. They have higher price-to-earnings ratios; thus, an investor who purchases a growth stock is paying a higher price per share because he or she believes the stock price might go even higher.
Clearly, value and growth are relative measures. In fact, evaluating a stock’s price (in value versus growth terms) is much like trying to determine if the price of a home you are interested in buying is priced right. Rather than wax philosophical, let’s focus on the results of actual value and growth US stock market indexes.
Does It Make a Difference?
As reported in Table 1, the 26-year annualized return of growth-oriented large-cap U.S. stock was 8.60 percent (which represents the average of the Russell 1000 Growth Index and the Lipper US Index of Large Growth funds). The term cap is an abbreviation of capitalization. Capitalization is the way in which stocks are size classified (large-cap, midcap, small-cap). Capitalization is calculated by multiplying the current price of a stock by the number of shares that have been sold to investors.
The two value-oriented large-cap U.S. stock measures in this study (Russell 1000 Value Index and the Lipper US Index of Large Value funds) had an average return of 9.03 percent over the period 1990–2015. Large-cap U.S. stock with a value orientation had a higher 26-year average return than large-cap U.S. stock with a growth orientation. This difference in favor of value is referred to as a value premium. There was a value premium among large-cap U.S. stocks, which translated into a total dollar premium of over $9,200 during this particular 26-year period (assuming a starting investment of $10,000).
The 26-year average annualized return of two midcap value measures (Russell Midcap Value Index and the Lipper US Index of Midcap Value funds) was 10.49 percent, considerably better than the 9.72 percent average return of the combined midcap growth indexes. The difference in performance amounted to a value premium of over $22,000.
Table 1: Annual Returns of Value and Growth U.S. Equity Indexes
|Annual Returns||S&P 500 Index||3-Month T-Bill||Barclays Aggregate Bond Index||U.S. Large Growth1||U.S. Large Value2||U.S. Mid Growth3||U.S. Mid Value4||U.S. Small Growth5||U.S. Small Value6|
|26-Year Average Annualized Return||9.29||2.89||6.26||8.60||9.03||9.72||10.49||8.32||10.19|
|26-Year Standard Deviation of Return||17.99||2.30||4.94||21.42||16.67||24.61||17.90||23.42||18.97|
|Growth of $10,000||$100,721||$20,999||$48,474||$85,435||$94,694||$111,584||$133,660||$79,878||$124,669|
Among small-cap U.S. equity, the value premium over the 26-year period was an astonishing 187 basis points (bps); that is, a 26-year value return of 10.19 percent minus a 26-year growth return of 8.32 percent equals a value premium of 187 bps. With a 26-year annualized return of 10.19 percent, small-cap value turned $10,000 into $124,669, or $44,791 more than the ending balance in small-cap growth.
The annual returns in Table 1 reflect performance from one point-in-time (January 1, 1990) to another point-in-time (December 31, 2015). Clearly, many investors won’t invest for that length of time or that specific period of years, so it’s useful to examine performance in smaller time frames, such as five-year periods. The performance premium for value and growth are calculated in rolling five-year periods of time and are reported in Table 2.
The premium (whether growth or value) for each five-year period is shown in basis points. For instance, over the five-year period from 1992 to 1996, large-cap value U.S. equity demonstrated a 240 bps premium over large-cap growth U.S. equity. Among midcap U.S. equities during the same period, there was a value premium of 203 bps. Among small caps, the five-year value premium from 1992 to 1996 was 363 bps.
As shown at the bottom of Table 2, large-cap value demonstrated a performance premium 50 percent of the time. The average five-year value premium was 462 bps. Conversely, large-cap growth outperformed large-cap value 50 percent of the time by an average of 274 bps.
Among midcap US equity, value outperformed growth 55 percent of the time by an average of 462 bps (over five-year periods). When growth outperformed value (45 percent of the time), the margin of victory averaged 271 bps. Among midcap U.S. stocks, a value tilt has historically provided better performance than a growth tilt.
Among small-cap U.S. equity, value beat growth 73 percent of the time by an average of 487 basis points (again, over five-year periods). However, when small-cap growth outperforms (27 percent of the time), the difference can be large. For example, during the five-year period of 1995–1999, small-cap growth beat small-cap value by 860 bps. Overall, however, when small growth outperformed small-cap value, the average margin of victory was 324 bps.
A Few Words About Basis Points
There are 100 basis points in one percentage point. For example, Fund A has a return of 10 percent and Fund B has a return of 11 percent. The 11 percent return of Fund B is 100 bps higher than the 10 percent return of Fund A. Or if Fund A has a return of 10 percent and Fund B has a return of 10.01 percent, Fund B has a higher return by 1 bps. The basis point measurement system is the clearest way to compare returns.
Table 2: Value and Growth Premiums over 5-Year Rolling Periods
|U.S. Large-Cap Equity||U.S. Midcap Equity||U.S. Small-Cap Equity|
|Average Premium (bps)||274||462||271||462||324||487|
|Percentage of Time with Premium (%)||50%||50%||45%||55%||27%||73%|
These results do not argue for eliminating growth-oriented assets from a portfolio. However, this analysis does suggest that a value “tilt” may be justified in the long run.
The long-run advantage of a value tilt is illustrated in Table 3. As the length of the investing period increases (from one-year periods to three-year rolling periods to five-year rolling periods to 10-year rolling periods), the frequency of a value premium increases.
For example, between 1990 and 2015, large-cap value outperformed large-cap growth 54 percent of the time over the 24 three-year rolling periods. Over 17 rolling 10-year periods, large value beat large growth 65 percent of the time. Among small-cap indexes, small-cap value outperformed small-cap growth in 73 percent of the five-year rolling periods, but 82 percent of the time over rolling 10-year periods.
Table 3: Frequency of a Value Premium Rolling Time Periods (1990–2015)
|Frequency of Value Premium among US Equity|
|U.S. Large-cap Stock (%)||U.S. Midcap Stock (%)||U.S. Small-cap Stock (%)|
|26 One-Year Periods||50%||50%||54%|
|24 Three-Year Periods||54%||58%||50%|
|22 Five-Year Periods||50%||55%||73%|
|17 Ten-Year Periods||65%||76%||82%|
Value stocks can perform differently from other types of stocks, and can continue to be undervalued by the market for long periods of time.
Growth stocks can perform differently from the market as a whole and other types of stocks, and can be more volatile than other types of stocks.