Why do value stocks outperform growth stocks?
Growth Investing vs. Value Investing. Growth investors are willing to pay higher prices for companies that are expected to grow faster than their industry or the overall market. By comparison, value investors take on less risk and instead look for companies whose stock prices are below their worth.
Finally, when it comes to overall long-term performance, there's no clear-cut winner between growth and value stocks. When economic conditions are good, growth stocks on average modestly outperform value stocks. During more difficult economic times, value stocks tend to hold up better.
For example, value stocks tend to outperform during bear markets and economic recessions, while growth stocks tend to excel during bull markets or periods of economic expansion. This factor should, therefore, be taken into account by shorter-term investors or those seeking to time the markets.
Growth investing, however, has been shown to outperform value investing more recently. One recent article noted that growth investing had outperformed value investing over the last 25 years. Since 1995, value mutual funds have returned 624%, while growth mutual funds have returned 1,072%.
At times of rising inflation, the real value of one dollar today is higher than in the future. Hence, as the valuation of value stocks have more cash flow weighted in the short term, they would likely outperform growth stocks.
Value premiums have often shown up quickly and in large magnitudes. For example, in years when value outperformed growth, the average premium was nearly 15%. On average, value stocks have outperformed growth stocks by 4.4% annually in the US since 1927, as Exhibit 1 shows.
Some studies show that value investing has outperformed growth over extended periods of time on a value-adjusted basis. Value investors argue that a short-term focus can often push stock prices to low levels, which creates great buying opportunities for value investors.
The act of investing in growth stocks is known as growth investing, i.e., investing in stocks that experience continued growth. Value stocks are undervalued stocks that have the potential to grow and generate returns in the future substantially. Hence, they are priced much lower than similar stocks in the market.
Certainly, there is usually a positive correlation between the two. Slow-growth companies often sell at low valuations and high-growth companies often sell at expensive valuations. In an attempt to simplify, the two continuums are often merged into one, with value at one end and growth at the other.
In large part, supply and demand dictate the per-share price of a stock. If demand for a limited number of shares outpaces the supply, then the stock price normally rises. And if the supply is greater than demand, the stock price typically falls.
When did value outperform growth?
Value has a long track record of outperformance, dominating the period between 1970 and early 2007 on a cumulative basis. By contrast, Growth prevailed from mid-2007 until the COVID-19 pandemic, when Value started to outperform again.
For much of 2023, narrow market leadership (i.e., the Magnificent Seven stocks) and sizeable valuation gaps among equities widened the performance gap between large-cap growth and large-cap value stocks, with growth outperforming. This trend may create opportunities in value stocks for investors looking ahead to 2024.
A common perception is that value stocks are more cyclical and therefore more vulnerable to economic downturn. We find that this conventional wisdom is false: empirical evidence shows that value stocks actually tend to outperform in recessions.
| Company (TICKER) | Yearly EPS Growth Estimate (5-Year Average) |
|---|---|
| Merck & Company, Inc. (MRK) | 62.8% |
| Eli Lilly and Company (LLY) | 25.6% |
| AstraZeneca PLC (AZN) | 13.1% |
| Church & Dwight Company, Inc (CHD) | 9.1% |
Value stocks have consistently underperformed growth stocks for many years. Yet, there are some signs that 2024 could herald a change in trend. Underperformance in value stocks was exacerbated in 2023 as many growth stocks, in the tech sector, saw huge gains due to excitement around artificial intelligence (AI).
Our analysis considers these arguments and concludes they have merit, but our research suggests that four key factors drove the underperformance of value and the outperformance of growth over the past decade: inflation, real interest rates, the corporate profits growth rate and equity market volatility.
Since January 1991, growth stocks have outperformed value stocks by a ratio of two-to-one, according to a team of analysts at Jefferies. That's the widest margin of outperformance dating back at least 33 years, the earliest on record.
Much is made of Warren Buffett's conversion from his early days as a deep-value investor along the lines of his mentor Benjamin Graham to one who appreciates growth stocks. But Buffett remains a value investor at heart, and rarely pays up for stocks or businesses at Berkshire Hathaway (ticker: BRKb).
While growth stocks handily outperformed value from 2015 through 2021, 2022 was a different story. Growth stocks, represented by iShares S&P 500 Growth ETF (IVW), sank 30% in 2022.
However, several studies suggest that risk cannot be a source of the value premium. Lakonishok et al. (1994) (LSV) report that value betas are higher than growth betas in good times but are lower in bad times, a result that directly contradicts the risk hypothesis.
What are the advantages of value investing?
Value investing is an ideal way to take advantage of the power of compounding. When you reinvest the returns and dividends you earn from your value stocks, your profits grow exponentially over time.
A popular explanation is the leverage effect, which posits that a drop in the stock price raises the firm's financial leverage, resulting in higher equity risk and hence higher return volatility.
Some potential benefits of value investing include the potential for higher returns, lower risk compared to other investment approaches, and a focus on long-term value creation.
| Company | Performance (Year) |
|---|---|
| Rover Group Inc (ROVR) | 167.60% |
| Meta Platforms Inc (META) | 166.31% |
| Advanced Micro Devices Inc. (AMD) | 125.20% |
| Palo Alto Networks Inc (PANW) | 113.57% |
The idea is simple, take the P/E ratio and divide it by the expected growth rate (typically the 5 year annualized growth rate). A PEG ratio below one can be interpreted as undervalued. Some people believe this ratio is better as it incorporates the growth rate into the P/E.
