This year has been a tumultuous year for the stock market. The S&P 500 was down about 30% at one point this year before quickly bouncing back. During the early stages of the rebound, "growth" stocks outpaced "value" stocks by quite a bit. However, this trend has been reversing recently. What is a "value" stock and what is a "growth" stock? Why would we expect them to perform differently? In this blog post, we will help answer these questions.
Value and growth stocks are characterized by their stock prices relative to certain metrics such as the book value (or net worth) of a company, earnings, cash flow, and even sales. Stocks with high prices relative to these metrics are known as "Growth" stocks, while stocks with low prices relative to these metrics are known as "Value" stocks.
Why do these stocks perform differently? Is there a reason why value should outperform growth? The answer cannot be boiled down to one factor, but economic intuition as well as history tells us that value should outperform growth in the long run. Think of buying a house rather than investing in a stock. Let's say there are two identical houses on the same street. One house is listed for $300,000 and the other one is listed for $315,000. Which one is more appealing? Unless you have good reason to believe the higher priced home, the one listed for $15K less offers a better value. When investing in growth stocks, often investors are simply jumping on the bandwagon and hoping to ride the wave higher. Many growth and value companies will have similar characteristics, but value stocks tend to be cheaper relative to their earnings or company net worth. Why pay more for the same thing? This is why we intuitively expect value to outperform growth over time.
What does history tell us about this? Does the data back up the economic intuition? The answer is, in fact, yes. A study done by Dimensional Funds, using U.S. stock market data from 1928 – 2019 shows us that yes, value does tend to outperform growth over the long term. On average, value stocks have outperformed growth stocks by 4.54% during this period.
As you may have noticed in the graphic, these premiums do not necessarily show up every single year like clockwork. There may be periods where growth will outperform value (the most recent decade being the most significant stretch), but these periods are often followed by value significantly outperforming growth.
One other interesting fact you may have noticed was that there is no discernable pattern in which type of stocks (growth or value) will outperform each year. The data shows that there is a level of randomness to which segment of the stock market will outperform each year. Just as we tell investors to stick with their asset allocation through the good times and bad times, to earn the "value premium" you must stick with your allocation to value-oriented stocks over the long term. Failure to maintain your discipline at the wrong time can mean losing out on these premiums when they turn positive again.
When it comes to value versus growth in the stock market, value has both history and economic intuition on its side. Although in any given year growth may outperform value, history tells us you are rewarded for maintaining a value discipline when investing in the stock market.