Growth stocks have been on such a roll for so long that they have upended the time-tested stock market relationship of value vs. growth stocks. While growth regularly has its day in the sun, value stocks — which are by definition bought at a discount — always outperform over the long run.
XGrowth led a sharp stock market sell-off Thursday as Treasury yields moved to multiyear highs, but that's just a blip for now. Value stocks have underperformed so dramatically since 2010 that growth stocks now hold the upper hand over the past three decades — topping the quarter-century of outperformance reached just before the dot-com bubble burst.
That's set off a high-stakes debate. Either value investing is dead — as the king of value investing Warren Buffett's big investment in Apple (AAPL) might suggest — or the stock market is upside down and poised for a dramatic reversal of fortunes.
Neither point of view makes a lot of sense. Contrary to the 1999-2000 bubble, growth stocks have earned their premium over value with world-beating results. Yet while finding unappreciated value in stocks has become harder, with more down-on-their-luck companies deserving their low valuations, value investing can still pay off.
"Value stocks are either cheap for a good reason or cheap because of (unfairly) low expectations," Patrick O'Shaughnessy, CEO and Portfolio Manager at O'Shaughnessy Asset Management, told IBD. "The market has left a lot of these stocks too cheap," he said, but he can't tell you when things will turn around. "Any good value investor knows how to suffer."
Value Vs. Growth Stocks Defined
When people say value stocks are in their longest losing streak vs. growth stocks, they are generally talking about the Russell 1000 Value Index vs. the Russell 1000 Growth Index. Based on cumulative returns, including reinvested dividends, value investing's underperformance now dates back to the late 1980s.
Russell 1000 Value stocks have lower price-to-book ratios (the value of equity divided by assets on the balance sheet) and lower growth forecasts. Russell 1000 Growth stocks have higher P/B ratios and estimated growth rates.
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In practice, many stocks don't fit neatly into the growth or value investing plays. Russell deems about 280 stocks partially growth and value, rather than all growth or value.
Back in 2013, when value investor Carl Icahn started buying Apple stock, it was 24% value, 76% growth. After Icahn sold his Apple stake and Warren Buffett's Berkshire Hathaway (BRKB) started accumulating its shares, Apple was 100% growth.
Growth Stocks Are Dominating For Good Reason
Growth stocks' era of dominance reflects fundamental changes in the economy and the rise of superstar companies using their might to disrupt one industry after another. These trends are too powerful to expect a big payback.
Growth stocks' upside surprises have often come at the expense of downtrodden value stocks. "Value stocks are being constantly disrupted by the companies that tend to be the fastest growers," said Ed Yardeni, chief investment strategist of Yardeni Research.
Barnes & Noble (BKS) may be seen as the ultimate value stock with a dividend yield in excess of 10%, but who can be sure the company will stick around long enough to make investors whole?
The biggest growth companies are "generating an enormous amount of cash" — too much to invest in their core businesses, Yardeni says. So they keep finding new industries to enter that are ripe for disruption. Think Amazon.com (AMZN) pushing into prescription drug delivery and Alphabet's (GOOGL) Waymo in the race for self-driving cars.
However, some of those superstar stocks, notably the FANGs, are pulling back to various degrees, especially Facebook (FB). Facebook faces a "toxic brew" of slowing growth and rising regulatory risk, according to MoffettNathanson. Google-parent Alphabet and Amazon also face calls for more oversight or regulation.
That's one reason for the Dow Jones' outperformance in September vs. the tech-and-growth-heavy Nasdaq.
Value Stock Winners
Though the value investing universe is littered with companies that can't get off the mat, there are still real bargains to be found that can pay off in a big way.
Take HCA Healthcare (HCA), the hospital operator whose stock went nowhere for 2-1/2 years before suddenly exploding 50% higher in 2018. Or Twitter (TWTR), whose growth hiccups landed the social media company on the Russell 1000 value index, only to see shares more than triple in the 15 months through June.
Great Value Stocks Don't Remain Value Stocks
Twitter, which has lost some luster lately amid regulation threats, helps explain why hand-wringing over value stocks is somewhat overwrought.
For one thing, value stock winners don't remain value stocks for long. At the end of June, the Russell 1000 Value index kicked out Twitter. At last check, the Russell 1000 Growth Index had a 34% tech weighting, with Apple, Amazon, Microsoft (MSFT), Facebook and Alphabet comprising 27%. Meanwhile, tech makes up a single-digit-percentage share of the Russell 1000 Value Index, led by AT&T (T), with a 1.7% weighting.
By far the biggest industry group weighting in the Russell 1000 Value Index belongs to financial services at 29%. Health care takes up 14% and energy 11%.
So historically low interest rates and contained oil prices, key to the long economic expansion, have thrown a wet blanket on 40% of the value investing index.
"Russell 1000 Value stocks have often been cheap for good reason," O'Shaughnessy wrote in a July investor letter. "Think here of the major energy companies, like Exxon Mobil (XOM), which have represented among the largest weights in the index."
Low long-term interest rates have been a drag on bank stocks as the yield curve has flattened. But those low rates also help elevate growth stocks, whose future cash flows look more valuable.
So the long-term rate outlook is one key to the question of whether value investing is ready to outperform growth.
Are Bank Stocks A Value Investing Play?
JPMorgan Chase (JPM), Goldman Sachs (GS) attempted as the 10-year Treasury yield powered to a fresh 7-year high.
Oppenheimer analyst Chris Kotowski argued in a Sept. 19 note that bank stocks are an unusually attractive value. He wrote that even as bank balance sheets are more solid than they've been in more than three decades, bank stocks are trading at 66% of the average S&P 500 P/E ratio. That's well below the 73%-80% norm.
A period of major outperformance could be in the offing, he said. However, if a Treasury yield curve inversion is coming in 2019, as Morgan Stanley has predicted, banks' net interest margins will continue to suffer.
Bank stocks have struggled to outperform the S&P 500 index for significant stretches over the past decade. Since a short-term Sept. 20 peak, JPMorgan and other bank stocks have pulled back. O Thursday, Oct. 4, bank stocks rallied with bond yields but soon pared or erased early gains. The Financial Select Sector SPDR (XLF) is just above a 23-month low vs. the S&P 500 index, according to its relative strength line.
Some value connoisseurs also blame the explosive growth of passive investing in exchange traded funds for value stocks' long underperformance. Those flows go into ETFs heavily weighted toward giant growth stocks.
Value Stock Index Vs. Value Investing
Tracking value stocks in an index is somewhat contrary to the notion that value investing is more art than science. Passive index investing casts a wide net based on mathematical inputs. Yet while low valuations may signal a promising area, value investors get their hands dirty, akin to panning a river bed for gold.
O'Shaughnessy tries to avoid "fool's gold" companies that look cheap based on price-to-book ratios but are expensive on other metrics. "Veiled value" stocks, on the other hand, may even be lumped into the Russell 1000 growth index because of high price-to-book ratios, but are deceptively cheap, he says. Boeing (BA), with a hefty R&D investment not reflected in its book value, was a classic example of "veiled value" before it went on a huge run starting in late 2016.
Richard Rosen, senior portfolio manager at Columbia Threadneedle Investments, seeks companies that have "low expectations with a catalyst."
"When disruption hits, great companies do what great companies always do — they restructure their businesses, both operationally and cost-wise, so that when conditions inevitably improve, they thrive like never before," Rosen wrote. "Whether we find value in the biotech space, supermarkets or retailers, there are great opportunities developing for the next cycle ahead."
Rosen says he's a firm believer in "reversion to the mean and buy low, sell high." He says he's confident that value investing's day is coming, even if he admits not knowing when.
Value Stocks Earnings Sluggish
The main culprit behind value stocks' unusually weak relative performance is clear: unusually weak earnings growth.
O'Shaughnessy Asset Management broke down the performance of the Russell 1000 Value and Growth indexes into three factors: EPS growth; an expansion of the earnings multiple of companies remaining within each index; and multiple expansion from index turnover.
The last category confirms that investors can reap rewards for finding companies whose value has been knocked down too far. From June 2010 to April 2018, O'Shaughnessy finds that the multiple expansion accorded to companies joining the Russell 1000 Value Index added an annualized 8.3% to the index as the stock market re-rated the companies higher following their inclusion.
But over that same period, earnings growth of Russell 1000 Value Index components grew just 1.8%. That pales vs. the 17.7% EPS increase for Russell 1000 Growth Index companies. It's also lousy vs. the value stock index's 7% EPS growth from 1965 to 2010.
Growth Stocks Not Expensive Vs. Value Stocks
Unlike during the dot-com bubble, growth stocks don't look especially expensive relative to value. Thus, there's no reason to expect a big reversal this time.
"Relative P/E ratios have gone nowhere for 16 years," wrote Morningstar researcher John Rekenthaler.
The P/E ratio of the Vanguard Growth Stock Index reached 2.5 times that of the Vanguard Value Stock Index at the start of 2000, then sank to 1.5 times by 2002. It's stayed at 1.5 times, with a few small wiggles along the way.
"The P/E evidence indicates that growth stocks have earned their way to their success, rather than being buoyed by higher investor sentiment," he wrote.
Relative price-to-book ratios of growth vs. value stocks tell a slightly different story. They've crept higher since 2002, but are well off their 2000 heights.
It's not just the FANG stocks. The software sector has been a market leader throughout 2018, with Adobe Systems (ADBE), Salesforce.com (CRM) and Fortinet (FTNT) among the many delivering powerful earnings growth.
Will Regulation Tilt Value Vs. Growth Stocks Trend?
"One could reasonably argue that it's acceptable for the relative P/B levels to rise, given that today's leading growth companies have unprecedented powers," said Rekenthaler.
In fact, one argument that value stocks are due for an era of superior returns is that today's superstar companies are gaining too much market power — so much so that an antitrust push or other restrictive regulation could be in store.
"So how could things return to normal? 100 years of data says value has always found a way to come back. If I am to speculate, it could be regulation," wrote Chad Slater, joint chief investment officer of Morphic Asset Management.
Citigroup just called for Amazon to split in two, a cloud computing company and a retail business, to avoid antitrust scrutiny.
Facebook, Google and Twitter all face continued broad-based political pressure and regulatory risk over Russian election interference. President Trump claims social networks and search results are biased against conservatives.
In addition to the risk of regulation itself, tech giants are spending heavily to address concerns. Facebook is staffing up substantially to root out fake news and fake accounts.
But no one should hold their breath waiting for regulation to turn the value tide. In the meantime, value investors have been adapting.
Buffett, who once eschewed tech stocks and sang the praises of chewing gum, has made Apple his largest holding.
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