MARKET COMMENTARY

Growth vs. Value: Finding the Sweet Spot

05.16.2018 - Carin L. Pai, CFA

For the past decade or so, economic and market conditions have been generally favorable for US growth stocks.

The economy grew at a slow and steady pace, rates remained anchored near historic lows and inflation was benign. As a result, growth’s outperformance has been dramatic: Large cap growth stocks returned an average of 11.4% annually over the past ten years and large cap value returned 7.4%, aided by a few relatively brief periods of outperformance in 2013 and 2016.

Growth Has Outperformed for Almost a Decade, but Conditions Are Changing

Source: Strategas Research Group (Ibbotson, Russell, FactSet) Based on annual total returns, indexed to 100 French-Fama from 1990 through 1978, Russell from 1980 through 2017.

But the conditions that supported growth are changing: The economy is gaining momentum, rates are poised to rise, and concerns about higher inflation have surfaced. Naturally, this raises an important question for equity investors: As the landscape changes, will growth stocks be able to extend their persistent winning streak? While it is impossible to predict the future, a look at the performance of growth and value stocks during previous economic and market cycles could offer valuable insights into what’s ahead.

Growth and Value: Two Different Styles

First, some basic definitions. Growth and value are two different styles of equity investing that seek the same goal for equities—capital appreciation. One way to understand the difference is to look at the emphasis they place on a stock’s price and the company’s earnings, the two elements of a stock’s price-to-earnings (P/E) ratio.

Growth investors focus mainly on earnings, looking for companies with the potential to growth their earnings, revenues or, ideally, both. But value investors are more interested in price, looking for stocks they believe are trading at a discount to their intrinsic value, based on their price and their fundamental strengths, and therefore offer a “margin of safety.”  Value investors seek to capture gains when economic and market and conditions change, and the price of the stock bounces back.

Economic Cycles Influence Performance

In terms of performance, growth and value have traded leadership roles throughout the ups and downs of various economic cycles and each style is influenced by a wide variety of factors. Outperformance can continue for years, or it can be fleeting. But when we examine performance trends over the long term, it becomes clear to us that certain conditions tend to favor one style over the other.

As a category, growth stocks perform best during the middle and late stages of an economic expansion cycle, when growth becomes scarce. But value stocks tend to perform best at two distinct and extreme turning points, driven by the economy and financial conditions.

First, value’s performance is strongest when the economy appears to be approaching a crisis, such as a recession, because the most defensive sectors in the value category tend to be more resilient to economic slumps. For example, spending on consumer staples tends to hold up relatively well when the economy is stressed because consumers still need basic necessities. Likewise, telecom and utilities offer stability because consumers still need to pay their phone and electric bills, and these sectors are also considered proxies for bonds, offering a strong yield component during downturns in the economy when corporate growth and price appreciation become more challenging.

We saw a prime example of this trend in 2015 and early 2016 when deflationary fears pushed investors into sectors that are known for their income and capital preservation qualities, lifting valuations to levels we found difficult to justify. Our focus on high-quality growth stocks was rewarded when the economy stabilized and markets re-adjusted later that year.

Second, value tends to outperform after the economy has bottomed out and is starting to accelerate, i.e. when a “rising tide lifts all boats.” The fact that value stocks are starting from a lower base than growth stocks also contributes to their outperformance. Within the value category, individual stocks can also surge when a company announces a restructuring or makes another one-time change that lifts its stock price from a relatively low starting point.

In both of these economic phases, financial conditions tend to be more accommodative and the Fed is usually in an easing mode—a key ingredient for value’s outperformance.

All Sectors Have Growth and Value Characteristics

Each of the 11 sectors in the stock market has a varying degree of growth and value characteristics, generally tilting in one direction or the other. Therefore, an index that tracks growth stocks is weighted more heavily in sectors that exhibit the strongest growth characteristics, while value indexes are weighted more heavily in value-oriented sectors. Those weightings need to be adjusted as the economy and market conditions change.

Consider the healthcare sector, for example. When biotech stocks are driving its growth, healthcare exhibits stronger growth qualities, because momentum in biotech earnings tends to be sustainable. But a rally in pharmaceutical stocks often emphasizes the value qualities of the sector, because pharmaceuticals have a strong yield component. Another example is the technology sector. Although it is considered the strongest of all growth sectors, many underlying stocks have characteristics associated with value investing. So its value characteristics tend to become more pronounced during certain stages of the product development cycle and the performance of its underlying securities.

Moreover, growth and value styles are nuanced—ranging from the most aggressive, high-risk stocks on the growth end of the spectrum to deeply discounted, distressed securities on the value side.

Our Approach: Growth at a Reasonable Price

Our approach to growth versus value in all economic environments is finding what we believe is the “sweet spot” between the two ends of the spectrum. As fundamental investors, we focus on companies that offer growth at a reasonable price—the core of the equity market. We favor companies with healthy balance sheets, a strong track record of consistent earnings growth and attractive valuations.

More specifically, the types of growth stocks we favor are typically associated with established companies that are dominant players in markets that are growing. They may also be gaining market share, which leads to improving cash flows and a healthy return on capital. Their competitive advantages keep costs contained and drive demand for their products and services without depending on the benefit of a strong economic tailwind. Therefore, these companies are usually well-equipped to “self-fund” their expansion efforts rather than relying on cheap sources of financing when the cost of borrowing is low.

What’s Ahead? Expect Changes, But Not a Reversal

If the US economy continues to strengthen, rates rise as expected and inflation gains momentum, we would not be surprised to see the outperformance of growth moderate. But we do not expect a sharp reversal in leadership roles. At this point, the economy does not appear to be rebounding from a bottom or heading toward a recession—two environments that favor the value category. 

Additionally, an extended period of low interest rates in the US has contributed to an extremely unusual set of economic and financial conditions. But as rates move closer to “normal,” value-oriented companies that rely on cheap financing to drive their growth could encounter new challenges. When bond yields rise, income-oriented investors may find high-dividend-paying stocks with little or no growth less attractive.

Undoubtedly, the US and global economy will continue to evolve over the course of the next several years. As they do, we will continue to look for stocks that provide our clients with high-quality growth opportunities that help them reach their long-term goals.

This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of May 8, 2018, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods. 

CFA® and Chartered Financial Analyst® are trademarks owned by CFA institute.

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