The value style of investing, which favors stocks with lower price-to-book ratios, for example, outperformed significantly in 2016. Indeed, the Russell 3000 Total Return Value Index surpassed the Russell 3000 Total Return Growth Index by 11.0% last year.
However, growth-oriented investment strategies, which emphasize equities with higher forecasted earnings growth rates, have been doing better so far in 2017. Specifically, the Russell 3000 Total Return Growth Index has outstripped the Russell 3000 Total Return Value Index by 2.1% year to date.
Was the value upswing just a passing fancy, and is growth here to stay?
True, growth has been getting a bit of a reprieve over the past few weeks, but that’s to be expected after a year in which value outperformed by double digits. Moreover, three weeks of outperformance aren’t enough to call for a wholesale shift back to growth. From our perspective, the fundamental catalyst for the rotation to value – namely higher expectations for earnings growth – remains in place (Exhibit 1).
Why do higher expectations for earnings growth favor value over growth? There are a couple of ways to think about it. First, value requires a catalyst (e.g., earnings growth) to unlock the opportunity embedded in share prices.
Second, when earnings growth is relatively more abundant, it’s less important to pursue growth-oriented investment strategies. By contrast, when the world is starving for earnings growth, investors flock to the companies that, by definition, provide the fastest expected earnings growth rates. In other words, earnings growth and the performance of the growth style of investing are inversely related.
Growth Is Defensive, Value Is Cyclical
Understandably, when investors consider growth stocks, many recall the Technology, Media and Telecommunications (TMT) growth bubble of 2000 and think that they’re synonymous with aggressive, higher-beta, cyclical equities. Outside of those extreme distortions, however, history shows that growth (as defined by the Russell 1000 Growth Index) has actually been a defensive strategy, and the late 2007 to early 2009 market downturn was no exception as growth stocks significantly outperformed their value counterparts.
On the flip side, value stocks are often misunderstood as sleepy, lower-risk, defensive equities, when in fact the historical record demonstrates that value (as defined by the Russell 1000 Value Index) was actually a cyclical strategy as these stocks were usually among the first to gain traction in the earlier stages of economic recoveries.
Buy Value Stocks on Pro-Growth Policies
In our 2017 Outlook, The Cycle Continues, but the Risks Are Rising, we made the case that the Trump administration’s readiness to deliver fiscal stimulus could propel U.S. and global economic growth. While it’s still early, the new administration’s promise of pro-growth policies are already manifesting in the form of higher earnings expectations, providing the catalyst for a continued rotation into value-focused investment strategies.
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