History suggests that value stocks beat growth stocks over the long run. Investors are compensated for the risk of owning troubled companies with low-priced shares. While short-term investors chase trendy growth stocks whose price-tags overestimate their prospects, longer-term shareholders prefer companies that under-promise and over-deliver.
But recent market behaviour has left many investors wondering when value will come back into fashion. Of course, predicting the timing of market turning points is a fool’s game. The unexpected, powerful, and ultimately short-lived rally in value stocks after the US election demonstrates this point.
Valuation, however, can be used to predict long-term future returns both for growth and value styles. Applying Morningstar’s equity analysts’ valuation estimates to value and growth indices, it appears that US market valuations imply higher future expected returns for value stocks. But, the wider stock market’s advance since 2009 has left most stocks overpriced, including those with a value tilt.
Some Lessons from Recent History
In 2017, the Morningstar US Growth Index’s 29.5% gain more than doubled that of the Morningstar US Value Index, which recalls the dotcom bubble at the turn of the century: in 1998, the Morningstar US Growth Index returned 39.8% versus the Value Index’s 14.1% gain. In 1999, the Morningstar US Growth Index advanced 44.5% while the US Value Index declined 1.3%.
Then the bubble burst and the tables turned: in 2000, the Morningstar US Value Index gained 10% while the Growth Index lost 28.5%. The Value Index suffered far less than the Growth Index in the bear market of the subsequent two years.
The financial crisis hit value investing hard: the Morningstar US Value Index fell 58.8% from August 1, 2007 to February 28, 2009, when the current bull market started. To be fair, the Growth Index also declined 45.2% over that span.
But growth has led value off the 2009 stock market bottom. Sector popularity is part of the story: financials, traditionally a value sector, haven’t fully recovered from the crisis; the rise of Amazon has crushed the retail industry; and certain technology companies have booked record profits.
The fact that the highest-flying growth stocks are referred to by an acronym – FAANG for Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Google (GOOGL) – makes it easier for investors to jump on the bandwagon.
What Can Investors Do?
Morningstar equity analysts assign fair value estimates to roughly 1,500 companies where economic moat, or sustainable competitive advantage, is a critical input. A company with a moat around its business might look expensive according to price/earnings ratios, but still be undervalued due to its ability to sustain profits.
Ultimately, we believe that share prices converge with fair value. Of course, one could sell out of stocks altogether, though timing the market is notoriously difficult. Staying diversified across styles, company sizes, geographies, and stocks, bonds, and other asset classes is also sensible. Within equities, there’s also the option of being selective: undervalued companies in the "wide moat" portfolio selected by Morningstar analysts include four-star rated Starbucks (SBUX), Disney (DIS) and 21st Century Fox (FOXA).
