Value or Growth Stocks - Which Deliver Higher Returns?

Value versus Growth

What delivers higher returns for investors - value or growth stocks? This ongoing debate continues apace. Put simply, investing in value companies implies buying stocks at low price-to-earnings, price-to-book and high dividend yields. Investing in growth stocks implies just the opposite.

Although a number of studies have been published over the years showing the ability of one investment style to prevail over the other, there is consensus that value investing outperforms the growth style over the long term.

However, we should bear in mind that value strategies are not considered low risk and can produce long periods of poor performance. Nevertheless, when we compare the cumulative performance of the MSCI Value index versus the MSCI World and MSCI Growth indices since their inception (1975), we would observe an excess return of 173.5% versus the former and 373.95% versus the latter.

Despite the superior performance over the period under analysis, this second chart highlights how value investing has demanded a high tolerance for underperformance in several periods and in recent years. After a prolonged period of underperformance, is it now a good time to ask if the value style finally offers a good opportunity for investors?

MSCI Value Relative Performance
Still Suffering?
Historically, we have seen that when value stocks underperformance ends, returns can be very interesting in the succeeding years. This has happened consistently each time with a wider performance gap between the two styles. Since the financial crisis, value stocks have been having difficulties. The outperformance as exhibited in the chart above up until 2007 contracted sensibly before turning negative in 2015. There are several reasons why this happened but it has been driven mainly by yield and inflation levels heading lower.

We can also analyze data from a different angle. When we invest in a fund, the typical holding period required to achieve the expected outcome is about five years. The chart below shows that, using this metric, value outperforms growth across most five-year periods. However, since 1975, there have been four periods when growth outperformed value on a rolling five-year return basis. We can also see that we are currently in one of these periods and the value rebound has yet to occur.
Value vs Growth Styles

Catalysts
While we may find cheap valuations across all sectors, remember that the value style has a bias towards financial, commodity and energy stocks. These sectors have suffered in recent years mostly due to the impact of QE from central banks. Low rates around the globe attracted investors to higher yielding and defensive sectors. Now, with inflation and yields picking up, this could reverse which would favour value once again.

Since the end of September, the evidence would support this as value has outperformed growth by almost 6%. The economic outlook has not changed materially but the view of central bank policy has. The Bank of Japan does not want to buy 10 year bonds below 0%, the Fed is inclined to increase interest rates and the Bank of England has indicated it is not totally impervious to the exchange rate and the inflation implications that it holds. Monetary policy is likely to remain easy but it is not easing at the same rate as it did over the last twelve months. The ‘change in the rate of change’ may be enough to start that value recovery.

It is important to note that in recent times we have seen short term inflation picking up in most developed economies as oil prices first stabilized and then started raising. Although this is more a mechanical movement due to the base effect than a proper trend, it is, at least, a sign that inflation is moving in the right direction. This is especially positive for financials.

In relation to commodities (e.g energy), two factors might be considered relevant to make a case for the sector. A general reduction of over-supply and an increase of restocking with a sustained and durable trend (especially from China). Even in this case there is no clear trend but there are signs of a change.

In the energy sector, supply/demand dynamics are also key. According to the latest data available, the level of OPEC and Non-OPEC over supply is relatively small when we consider current demand. If US shale oil production continues declining, a growing demand should continue to sustain an increase in oil prices and ultimately, the level of (non-Core) inflation.

An additional catalyst that could support the case for value investors is a pure technical phenomenon called mean reversion. Simply put, when the differential between value and growth becomes too stretched when compared historically, the probability of a change-over is increased. This could be happening soon, and should lead to substantial benefits for the affected sectors noted above.

It is also worth highlighting that while catalysts are necessary to see a rotation happening, bottom up stock picking is fundamental to achieve the desired results. Just because something is cheap does not automatically imply that it is good value. A famous investor, Benjamin Graham, always highlighted that losses are the result of buying low quality at a price that looks good value rather than quality at an excessively high price.