Growth vs. Value: Diversification May Yield Best ResultsMarch 22, 2017
- Large-cap growth stocks significantly outperformed large-cap value stocks in 2015, but this trend reversed in 2016.
- Value stocks' recent outperformance may be attributable to rising interest rates, along with strong performance from the more value-oriented financials and energy sectors in the final months of 2016.
- Consider maintaining a diversified U.S. equity exposure that incorporates both deep-value stocks and high-expectation growth stocks.
Stock investors may wonder which investment style they should follow: growth or value? Growth investing focuses on faster-growing but more expensive shares, while value investing seeks out cheaper companies that often are mature or growing more slowly for other reasons. There are good arguments to support the separate cases for each. However, the best solution for many investors may be to employ a broadly balanced growth and value approach.
History doesn't provide much assistance in choosing a growth or value strategy at any point in time. Historical data show that there is almost no relationship between the relative returns from growth and value stocks from one year to the next.
The chart below illustrates the yearly relative performance of U.S. large-cap value stocks versus U.S. large-cap growth stocks, with little discernible pattern over time. Indeed, sector-specific factors appear most influential in determining one investing style's outperformance.
In the late 1990s, for example, the rapid ascent of technology-related companies saw growth sharply outperform value, before reversing completely in early 2000 in the wake of the dot-com bubble collapse. Conversely, the global financial crisis negatively impacted value stocks—particularly the financials sector—and they underperformed growth sharply.
In 2015, growth stocks beat the returns of value stocks by 9.5%, but the results were reversed in 2016, when value stocks outperformed growth stocks by 10.2%.
Neither the Russell 1000 Value Index nor the Russell 1000 Growth Index has shown a consistent advantage since 1980. From one year to the next, either style could outperform the other by 20 percentage points or more.
Sources: FactSet, Russell, and T. Rowe Price.
The benefits of Growth
One current argument in support of the potential for growth stocks returning to outperformance is that valuations are not overly expensive. Growth has historically traded at a higher price/earnings (P/E) multiple than value, which stands to reason given the higher growth expectations of the individual companies.
Over the last 20 years, the growth stock P/E premium has averaged about 30%, according to various Russell indexes. At the end of 2016, however, the P/E ratio on growth stocks was only 10% greater than that for value—substantially below the average.
The rate environment, while not ideal for growth investors, is generally benign. Interest rates should continue to move higher over the next couple of years, with short-term rates perhaps reaching 2% and longer-term rates around 5%. Historically, rising rates have not derailed the case for equities if accompanied by an improving economy. As long as the 10-year Treasury yield remains below 5%, the market still could perform reasonably well. Of course, past performance cannot guarantee future results.
Additionally, we expect a small number of innovative, uniquely positioned companies to continue to prosper regardless of the general market backdrop. Looking at the extent of change seen over recent decades, we likely have not yet seen the end of creative destruction, particularly in the technology sector.
Consider such innovations as the social networking explosion led by Facebook, the rise of the “sharing economy" driven by such firms as Airbnb and Uber, and the fundamentally altered retail landscape forged by Amazon. These types of companies tend to be growth oriented, rather than value oriented.
Another example of a high-quality growth stock is American Tower (AMT), the second-largest U.S. wireless communications tower operator by size (28,000 towers) and the premier international tower operator (41,000 towers). About two-thirds of its revenue and three-quarters of its operating profit come from the United States, with the rest from abroad.
We believe AMT is a very high-quality business, with predictable growth, low churn, high margins, low capital intensity, strong returns on capital, and robust free cash flow generation. The company continues to build its footprint in the United States and internationally, notably in India and Mexico, benefiting from its strong market position in a high-barrier industry.
Given the respective merits of both investment styles, it makes sense to maintain a diversified U.S. equity exposure.
The Benefits of Value
On the other hand, U.S. large-cap growth stocks' dominance since the financial crisis became stretched in 2016. The magnitude of that leadership had become much greater than normal. Historically, from such an extended level, value has tended to outperform growth over the subsequent five years—though there can be no guarantee that will be repeated.
Also supporting the value argument is the fact that valuation spreads within the market widened significantly in 2016, with the least expensive segment of the market becoming significantly cheaper relative to the most expensive stocks than has been normal. Historically, in the year following such situations, value stocks typically have gone on to significantly outperform the broader U.S. equity market.
Value received a boost late in the year from the strong performances of the financials and energy sectors. The energy sector made up more than 13% of the Russell 1000 Value Index as of the end of 2016 compared with less than a 1% weighting in the Russell 1000 Growth Index. Financials’ weighting stood at about 30% in the Russell 1000 Value Index versus about 5% in the Russell 1000 Growth Index.
Higher interest rates can pose a greater headwind to growth companies than to value companies. As with bond markets, longer-duration investments are more negatively impacted by rising rates, and growth companies tend to be longer-duration investments: They often are less profitable in the near term than value companies—though they are expected to be successful over the longer term. As a result of this earnings profile, rising interest rates pose a stronger headwind for growth companies.
An example of a high-quality value stock is Pfizer (PFE), a large-cap pharmaceutical company. The firm has struggled with patent expirations of certain drugs and the integration of several large-scale mergers. PFE's new strategy consists of reinvigorating its research and development process and divesting its non-pharmaceutical businesses (consumer products, infant nutrition, and animal health). PFE appears undervalued as a standalone company; a spinoff could unlock value.
A Case for Diversifying
Given the respective merits of both investment styles, it makes sense to maintain a diversified U.S. equity exposure. (See "Growth vs. Value vs. Blend.") That would incorporate both deep-value stocks displaying credible paths toward improvement, as well as high-multiple, high-expectation growth companies whose long-term potential remains underestimated by the market. Such a broad-based approach should ensure participation in any market advance, regardless of from which side of the style spectrum the leadership comes.
Investors who limit themselves to one investment style, including a blended style, are potentially missing out on returns. When you look at the top 10% of Russell index returns, no individual style (growth, value, or blend) has consistently dominated.
Sources: FactSet, Russell, and T. Rowe Price as of December 31, 2016. Top decile of annual Russell 1000 Index returns.
Past performance cannot guarantee future results.
Growth and Value Mutual Funds
T. Rowe Price provides investment opportunities for both growth and value fund investors as well as for a combination of the two.
Growth stocks tend to perform particularly well when markets are rising and investors are looking for rapidly growing companies. On the other hand, value stocks can help reduce portfolio volatility since they may outperform the overall market when prices fall. Buying value-oriented stocks that are currently out of favor or misunderstood can lead to significant gains when other investors recognize the stock’s real value.
Therefore, it makes sense to maintain diversified equity exposure that incorporates both deep-value stocks and high-expectation growth stocks. If you’re interested in a mutual fund that combines these two styles, T. Rowe Price offers a blended option:
T. Rowe Price U.S. Large-Cap Core Fund (TRULX)
Launched in 2009, the T. Rowe Price U.S. Large-Cap Core Fund offers investors an opportunity for long-term capital appreciation. The fund has the flexibility to invest in both growth and value stocks and will select whichever stocks—primarily among common stocks of large-cap U.S. companies—the managers believe represent the most favorable combination of company fundamentals, earnings potential, and valuation. The fund uses fundamental, bottom-up research and takes a core approach to stock selection, which includes both styles of investing: growth and value. Growth stocks tend to do well when markets are rising, but they can also experience sharp price declines as a result of earnings disappointments. Meanwhile, value stocks tend to outperform the market when prices fall, although the risk exists that the market will not recognize the company’s intrinsic value. The fund’s focus on large-cap companies typically makes it less volatile than funds that focus on small- or mid-cap stocks.
As of December 31, 2016, American Tower made up 1.38% of the T. Rowe Price U.S. Large-Cap Core Fund, while Pfizer made up 1.74%. Diversification cannot assure a profit or protect against loss in a declining market.
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