Going Out of Style? Explaining Growth’s Outperformance

Like fashion trends, investment styles tend to come into and out of favor over time. One of the more popular investment comparisons is growth versus value. But what, exactly, is a growth stock, or a value stock? Value stocks are those generally deemed to have below average valuations, as measured by metrics such as price-to-earnings or price-to-book ratios. These are stocks that may be considered “on sale.” Growth stocks, on the other hand, are those deemed to have higher than average earnings or revenue growth. These stocks are expected to be “fast growers.”

Growth stocks have significantly outperformed value stocks for most of the bull market following the financial crisis, with the Russell 1000 Growth Index outperforming the Russell 1000 Value Index by 93% from March 2009 through the end of 2018. Given growth’s dominance, many investors now wonder whether value is due for a comeback. While predicting style shifts is notoriously difficult, it is helpful to remember the factors that tend to favor one style over the other. Below are a few of the factors analysts have cited to explain growth’s recent outperformance.

Low Interest Rates
Low or decreasing interest rate environments have tended to favor growth while high or rising interest rate environments have tended to favor value. A company’s stock price is largely determined by the earnings it is expected to generate today and in the future. Growth stocks, compared to value stocks, are expected to generate more of their earnings in the future than today. As interest rates rise, a dollar of earnings in the future becomes less valuable than a dollar of earnings today. As future earnings decrease in today’s dollars, so too does the company’s stock price. Value stocks, which are generally more mature companies less dependent on future growth, are not as sensitive to higher interest rates. Value’s outperformance during periods of rising interest rates have demonstrated this phenomenon. In the years following the tech bubble, as the fed fund rate increased from 1% in June 2003 to 5.5% in June 2006, the Russell 1000 Value Index outperformed the Russell 1000 Growth Index by 28%. In recent years, interest rates have been relatively low since the financial crisis, benefiting growth.

Rewarding Growth in a Low-Growth World
Global growth in the years since the financial crisis has been subdued. Despite this, from January 2009 through July 2018 stocks in the Russell 1000 Growth Index have managed to grow earnings 84% compared to 34% for stocks in the Russell 1000 Value Index. Given the scarcity of growth, the outperformance of growth stocks may reflect a premium investors have awarded those companies for growing in an otherwise tepid environment.

Growth Was Cheap
Growth’s relatively low valuation at the start of the bull market may also have helped its outperformance. In March 2009, the Russell 1000 Growth Index traded at nearly the same forward price-to-earning ratio as the Russell 1000 Value Index, roughly 14x, according to Bloomberg consensus estimates. Compare that to the difference seen in the wake of the dotcom bubble in October 2002, when the Russell 1000 Growth Index traded at 23x, compared to 17x for the Russell 1000 Value Index. The relatively low valuation of growth stocks after the financial crisis may have de-risked those stocks generally and compelled investors to look for other factors to differentiate stocks, like earnings growth.

Sector-level Fundamental Headwinds and Tailwinds
Sector-level fundamental drivers may also be at play. The Russell 1000 Value Index is weighted toward the financial and energy sectors, both of which have faced secular headwinds – a flat yield curve for financials and subdued oil prices for energy. By contrast, the Russell 1000 Growth Index is weighted toward consumer discretionary and technology sectors, both of which have benefited from a stronger U.S. consumer and growth abroad. 

While it is helpful to keep in mind the factors that may explain why growth outperformed in the past, it is difficult to say whether those same factors will benefit growth going forward. With that in mind, the most suitable approach—the one we follow at West Financial Services—is to maintain exposure to both value and growth investing styles in order to benefit no matter which style may come into favor.

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• Information contained herein was derived from third party sources including Bloomberg, Standard & Poor’s, Dow Jones & Company, the Federal Reserve Bank of New York, and Morningstar, Inc. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any information presented. We have not and will not independently verify this information.

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