Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Jeff Rottinghaus, portfolio manager of the T. Rowe Price US Large-Cap Equity Fund, asks growth vs value: will dominance of growth style continue?
Historically, long-term value investors have achieved superior returns to growth investors – with lower overall risk. However, this knowledge would have served investors poorly over the past decade, as growth-oriented stocks outperformed value-focused counterparts by some margin.
Understandably, investors are asking a lot of questions about the outlook for growth and value in light of the recent divergence in relative returns. However, there are good arguments to support the case for both.
The Case for Growth
One argument in support of growth’s continuing outperformance is that current valuations are not expensive. Growth has historically traded at a P/E multiple than value, which stands to reason given the higher growth expectations of the individual companies. Over the last 35 years, this premium has averaged around 40%. At the end of April 2016, however, the P/E ratio on growth stocks was only 10%.
There is also little doubt that certain sectors of the US economy currently face greater challenges than others. We saw evidence of this in 2015, with the energy, materials, and financials sectors all coming under pressure. These are all areas traditionally associated with value investing. The energy sector, where earnings are expected to contract by around 60% in 2016, makes up more than 12% of the Russell 1000 Value Index, compared with a less than 1% weighting on the Russell 1000 Growth Index. Clearly, any further weakness in these areas will weigh on value-oriented performance.
At the same time, market expectations for many of the large growth-oriented areas – such as the healthcare, consumer and technology sectors – are far more positive, with earnings expected to increase by 10%, 7%, and 3%, respectively, over the balance of 2016.
In addition, we expect a small number of truly innovative, uniquely positioned companies to continue to exist, regardless of the general market backdrop. Consider the product innovation of companies like Apple (AAPL), the social networking explosion led by Facebook (FB), the rise of the ‘sharing economy’ via companies like Airbnb and Uber, as well as the fundamentally altered retail landscape driven by Amazon and its radical new distribution model. Truly innovative companies tend to be growth-oriented, rather than value.
The Case for Value
Analysis of historical US equity growth versus value returns shows that the recent period of the former’s dominance is looking stretched. Based on 65 years of data, the magnitude of growth’s current leadership over value has become pronounced, recently approaching 1.8 standard deviations from average. Historically, from such extended levels, value has tended to outperform growth meaningfully over the subsequent five years.
Also supporting the value argument is the fact valuation spreads within the market have widened significantly in recent months. The cheapest quintile of stocks relative to the broader market has become significantly cheaper, recently at 1.5 standard deviations from normal. From these levels in the past, value stocks have gone on to outperform the broader US equity market by an average of almost 17% over the following 12 months.
Finally, higher interest rates pose a greater headwind to growth companies than to value. As with bond markets, longer-duration investments are more negatively impacted by rising rates.
Which Style Should Be Followed?
Given the respective merits of both investment styles, it is reasonable to suggest that an approach incorporating both growth and value investments is the best way forward for many investors. Historically, the stocks that have generated the best annual returns have consistently come from both the value and growth ends of the market.
In 2015, for example, the stellar performance of the growth-oriented ‘FANG’ – Facebook, Amazon (AMZN), Netflix and Google (GOOG) – stocks was well documented. However, what is lesser known is that over 20% of the best-performing stocks in the market were value names.
Therefore, it makes sense to maintain a diversified US equity exposure – incorporating both deep value names displaying credible paths toward improvement, as well as high-multiple, high-expectation growth companies where the long-term potential remains underestimated by the market.
Disclaimer
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