The growth-and-value cycle

Growth has outperformed for years. History suggests that cycle will turn. But when?

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Last year, stock prices for companies with faster earnings growth outperformed their low-cost value peers. In fact, value stocks have now trailed growth for the past 3-, 5-, and 10-year periods. But while the past doesn’t provide any guarantees about the future, investors still may want to look at history: The market has historically gone through cycles when growth outperforms, but also periods when value outperforms.

“At times, value investors have to ride out periods of underperformance, but over the long term, value strategies have proven their ability to deliver performance for investors,” says Sean Gavin, portfolio manager of Fidelity Value Discovery Fund (FVDFX).1 “Investors shouldn’t overlook the appeal of value stocks as part of their diversified portfolios.”

Growth rallies end

Last year, a narrow group of stocks delivered positive performance for the S&P 500—with the top 10 stocks accounting for more than 70% of the total return of the index. The top stocks included Facebook, Amazon, Netflix, and Google—high flying growth stocks. But compared with the market overall, these stocks trade at high prices relative to their earnings.

“As growth slows, people tend to argue you want to find those few pockets of growth that can do well, and not worry about the price,” says Gavin. “Those might be great companies, but, historically, buying growth stocks at high valuations at the end of a cycle has eventually turned into a painful move.”

In 1998 and 1999, the story was in some ways similar. Another small group of tech stocks was leading the charge, with the top 10 stocks delivering 40% to 60% of returns. Then, as now, growth stocks outperformed value dramatically. Until they didn’t. Despite the big run-up in growth stocks in the late 1990s, value still outperformed growth over the 10 years from December 1991 to December 2001, and over every 10-year period until 2012.

While the difference in valuations between growth and value stocks has not reached the heights of the dot-com era, the relative performance of growth and value has reached a similar extreme, as shown in the chart “Growth versus value.”

“Markets go through cycles, and when you see over- or underperformance far beyond average, you have to resist the temptation to start believing that ‘this time is different’,” says Naveed Rahman, an institutional portfolio manager on Fidelity’s value team. “You want to make sure that you have a balance of growth and value that makes sense for you.”

Understanding the value-and-growth cycle

Recent history has seen an unusually long period of growth leadership. How will you know when it is going to end?

“We have been living through one of the longer periods of growth outperformance, but the fact that value underperforms later in an economic cycle is pretty typical,” according to Gavin.

Late in an economic cycle, when growth becomes scarce, investors tend to be willing to buy stocks that are still growing their earnings for higher and higher prices relative to their business fundamentals. Also, Gavin says, “The market typically gets bearish on value stocks late in the economic cycle, because these companies often face some structural or cyclical headwind, which looms larger when investors are concerned about a potential slowdown or recession.”

Those low expectations are important, because when actual results are less bad than expectations, value stocks tend to outperform. This often coincides with the beginning of an economic recovery or the normalization of economic circumstances.

“Value has demonstrated a historical ability to bounce back strongly after periods of relative underperformance,” according to Rahman. The chart below shows cyclicality of growth and value stocks by charting the relative performance of value and growth beginning when growth stocks first outperformed value stocks for a five-year period. As you can see, growth stocks often continued to outperform for some months, but then value strategies had their days in the sun.

Timing the exact moments when these cyclical changes happen has proven impossible to do consistently. Rather than trying to time the exact change in leadership, investors may want to consider their portfolio’s strategic exposure to value and growth.

Finding value in today’s markets

Investors have been chasing growth, but also paying up for quality stocks—companies with low debt, stable earnings growth, good returns on invested capital, and strong management. In fact, within the value world, high-quality stocks have rarely been as expensive relative to low-quality stocks. Gavin says that has shifted the opportunity set within the value universe.

“You always need to find a balance of value and quality, but the market is now paying you to look at shifting the mix toward lower-quality value stocks,” says Gavin. “But there are a lot of cheap low-quality stocks that just aren’t very good—so just picking blindly could create a huge amount of volatility in your portfolio. This is really a space where stock picking matters.”

The media space provides a good example of how these market trends may be creating value opportunities. Investors have been drawn to fast-growth companies that are disrupting the media space, including Amazon and Netflix. On the other hand, media companies have traded at exceedingly low multiples. For example, Viacom (VIAB) has a P/E of 7, 21st Century Fox (FOX) a P/E of 15, and Starz (STRZB) a P/E of 10. Gavin thinks investors are pricing these stocks as if these companies could go out of business in two to three years, and are underappreciating the value of their content franchises and the stability that their long-term contracts will provide.

Gavin says managed care companies in the health care sector may also offer value. He thinks some have been trading at low prices relative to sustainability of earnings. For instance, his fund has invested in CIGNA (CI), which has been going through a merger. Anthem has been attempting to buy the company, but the market has been struggling to price the probability of the merger going through. He thinks the stock may have upside potential, regardless of whether the deal goes through or not.

Looking for investments

If you are interested in adding value strategies to your portfolio, you have a number of options.

Fidelity’s mutual fund evaluator names the funds listed below as the top performing Fidelity and non-Fidelity funds in the large- and mid-cap value categories, based on three-year returns (results as of March 23, 2016). You should do your own research to find investment options that are appropriate for you.

Large Value Mid-cap value
Fidelity Funds
Fidelity® Value Discovery Fund (FVDFX) Fidelity® Mid Cap Value Fund (FSMVX)
Fidelity® Blue Chip Value Fund (FBCVX) Fidelity® Low-Priced Stock Fund (FLPSX)
Fidelity® Large Cap Value Enhanced Index Fund (FLVEX) Fidelity® Value Fund (FDVLX)
All funds
Wells Fargo Disciplined U.S. Core Fund - Class A (EVSAX) Glenmede Total Market Portfolio (GTTMX)
Lyrical U.S. Value Equity Fund Investor (LYRBX) Putnam Multi-Cap Value Fund Class A (PMVAX)
BMO Low Volatility Equity Fund Class A (BLVAX) Harbor Mid Cap Value Fund Investor Class (HIMVX)
Results for illustration only. Results from Fidelity’s mutual fund evaluator based on the top-performing Fidelity and non-Fidelity funds in the large and mid-cap value categories, based on three-year returns as of March 23, 2016. You should do your own research to find investment options that are appropriate for you.

If you are looking for individual stocks as part of a diversified portfolio, Fidelity’s stock research center has a number of screeners to help generate research ideas, including the Large Cap Value Screen from Zacks, the Franchise Players screen from EVA Dimensions, and more. You can also find ETFs in Fidelity’s research center.

The bottom line

Growth stocks have been on a great run, but investors may want to consider the historic performance patterns as they prepare for the future.

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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
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1. See Fidelity Learning Center for details comparing the results of value and growth stock market indexes. Over rolling five year periods from 1980 through 2010, large cap value outperformed large cap growth in 67% of periods by an average of 4.76 percentage points based on the average of the Dow Jones Large Growth Index and Dow Jones U.S. Large Cap Growth Index.
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