After a decade of growth stocks leading the way, we have seen value stocks have their moment in the sun, but what will 2023 deliver for the two investment styles?
When it comes to asset allocation, investors can choose from multiple models. Beside structured processes such as equal weighting the single securities in the portfolio or using the market capitalisation to determine the size of the positions, there are also discretionary methods to determine the weightings of holdings within a portfolio.
When it comes to the style selection of single stocks, there are only two basis models (value and growth) available, whilst all other considerable models are derived from or are a mixture of the two.
Value versus growth
To evaluate whether there are trends with regard to value and growth investing in the capital markets, we chose the Russell 1000 index and calculated the relative performance of the Russell 1000 Value and Growth indices.
In addition to this, we analysed the long-term performance of the Russell 1000 Value and Growth indices.
Before we look at the results from these calculations, we will look at the respective index methodology since this may help to explain the results of the calculations – especially since the methodology used for the respective Russell indices is somewhat different to the methodologies used by other index providers.
The index methodology of the Russell 1000 Growth and Value indices
For the example in Exhibit 5, FTSE Russell uses a ‘non-linear probability’ method to assign stocks to the growth and value style valuation indices. To determine the growth and value characteristics of a stock, FTSE Russell uses three variables. For value, price-to-book (P/B) ratio is used, whilst for growth, two variables – I/B/E/S® forecast medium-term growth (two-year) and sales per share historical growth (five-year) are used.
The term ‘probability’ is used to indicate the degree of certainty that a stock is value or growth, based on its relative P/B ratio, I/B/E/S forecast medium-term growth (two-year), and sales-per-share historical growth (fiveyear). This method allows stocks to be represented as having both growth and value characteristics, whilst preserving the additive nature of the indices.
The process for assigning growth and value weights is applied separately to the stocks of the base index (the Russell 1000). Stocks are ranked by their P/B ratio, their I/B/E/S forecast medium-term growth (two-year), and sales-per-share historical growth (five-year).
These rankings are converted to standardised units where the value variable represents 50% of the score and the two growth variables represent the remaining 50%. They are then combined to produce a composite value score (CVS). Stocks are then ranked by their CVS, and a probability algorithm is applied to the CVS distribution to assign growth and value weights to each stock.
In general, a stock with a lower CVS is considered growth, a stock with a higher CVS is considered value, and a stock with a CVS in the middle range is considered to have both growth and value characteristics and is weighted proportionately in the growth and value indices.
Stocks are always fully represented by the combination of their growth and value weights. For example, a stock that is given a 20% weight in a Russell value index will have an 80% weight in the corresponding Russell growth index. Style index assignment for non-pricing vehicle share classes will be based on that of the pricing vehicle and assigned consistently across all additional share classes.
Exhibit 5: Rolling relative one-year performance (in %) of the Russell 1000 Growth and Value indices compared to the Russell 1000 index
Can investors take advantage from the cyclical nature of the two styles?
Even as Exhibit 5 shows a clear picture when value stocks outperformed growth stocks and vice versa, this kind of comparison can’t be used to forecast which of the two styles will outperform the other in the near future, since the comparison used is a lagging indicator (rolling one-month calculation of the one-year relative performance to the Russell 1000). Nevertheless, the chart depicts that there are periods when value stocks show a superior performance compared to growth stocks and the other way around. This means it may make sense that investors tilt their portfolio in one or the other direction to capture the additional returns from the style shifts over time.
A closer view of the long-term performance of the Russell 1000 Growth and Value indices shows that there were only two periods when the Russell 1000 Growth index showed a significant outperformance compared to the Russell 1000 Value index. These periods were the so-called ‘dot-com bubble’ (30 September 1999 to 31 July 2000) and the period around the coronavirus crisis (31 December 2019 to 31 March 2023). Whilst it is clear why growth stocks outperformed during the dot-com bubble, the outperformance of growth stocks over the period around the coronavirus crisis and beyond has different reasons.
The main reason for the outperformance of growth stocks over the period of the coronavirus crisis can be seen in the lockdowns around the globe, which forced companies and individuals to readjust their lives and businesses to the new normal by moving their activities from the real world into the virtual space. The strong demand for online services drove the revenues of the respective companies up, whilst disrupted delivery chains and declining demand for manufactured goods led to falling revenues at old economy companies.
In addition to this, the rescue packages issued by governments and central banks around the globe led to an environment in which growth stocks looked very attractive from a valuation point of view, since low interest rates mean that higher earnings multiples are reasonable. This is also reflected in the downturn of growth stocks, when central banks, especially for this example the U.S. Federal Reserve, started to tighten their monetary policies.
A second reason for the outperformance of growth stocks over the coronavirus crisis might be the shift from conventional investing to environmental, social and governance (ESG) investing. Since most value stocks are active in the so-called brown sectors such as industrials, oil and gas, manufacturing, etc…, these stocks might have fallen out of favour when investors turned to ESG investing, which favours companies with an overall lower greenhouse gas footprint. Even as this shift is not over yet, rising interest rates and the respective readjustment of valuations seem to hold investors back from buying growth stocks in the current market environment.
Exhibit 6: Compound return (in %) of the Russell 1000, Russell 1000 Growth and Russell 1000 Value Indices
Growth and value investing seem to be two sides of the same coin and both investment styles have periods when one shows an outperformance compared to the other. Whilst growth stocks seem to be the investment of choice in periods with low interest rates, value stocks might be in favour when valuations are the main driver for investment decisions.
That said, value stocks are also often called orphan-and-widow securities, because these stocks do normally pay a high dividend, which is an independent stream of income for investors. Some investors see value investing as a less risky way to invest in the stock markets. Since the lower valuations give the investor a risk buffer, it is not necessarily superior compared to growth investing, as value stocks can have the same drawdowns as growth stocks.
Even though there are trends toward growth or value stocks, it is nearly impossible to find the right timing to shift from one investment style to the other. Regarding this, investors need to do intensive research on the current market momentum to switch from value to growth or the other way round. That said, investors may need to be patient when trying to do market timing, since some trends stay longer than expected, even as the market momentum has already started to change.
Therefore, the best way to leverage changing market trends regarding value and growth investing might be to simply choose the investment style that fits the needs of the respective investor best for the core of the portfolio and allocate the other style in the satellite portion of the portfolio.
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