Commentary by Kevin DiCiurcio, CFA, head of the Vanguard Capital Markets Model® research team.
Brighter days are ahead for US value stocks.
This might seem a relatively safe prediction. After all, shares in US companies with relatively low valuations and high dividend yields have outperformed their growth counterparts so far this year1. And as our research shows , the coming reversal of fortunes would restore the decades-long performance edge that academic researchers have ascribed to value stocks.
Investors, younger ones especially, may be sceptical. Powered by a relentless rise in technology share prices, growth stocks have outpaced value—the province of financial, utility, energy and basic materials companies, among others—since the 2008 global financial crisis.
Past performance is no guarantee of future returns.
Notes: The chart displays monthly observations of ten-year annualised total gross returns in US dollars for periods from June 1936 to January 2021 of a hypothetical long-short value versus growth portfolio constructed using Fama-French methodology
Source: Fama-French research returns.
To better understand past results and provide estimates of future returns, we identified fundamental forces—some secular, others cyclical—that drive changes in the value-growth relationship and constructed a related fair-value model. Our model suggests that value stocks’ underperformance in recent years owes mainly to fundamental drivers, particularly low inflation rates, which boost the relative attractiveness of growth stocks’ more-distant cash flows. But investor behaviour has played a role as well.
We expect US value stocks to outperform US growth over the next ten years by four to six percentage points, annualised, for a UK investor, and perhaps by an even wider margin over the next five years. To be clear, our outlook is for the style factors, or what might be termed “pure” value and growth portfolios. These differ from both the academic value-growth data presented in the first chart (using Fama-French methodology) and style-specific market indices that serve as benchmarks for many real-world investment portfolios.
The Fama-French data have the virtue of a long history, dating to the Great Depression. But few investors are in position to implement the academic definition of value, which includes holding the cheapest stocks while selling short the most expensive stocks2.
To assess the performance of investable value and growth portfolios, we constructed market-capitalisation-weighted indices of companies in the bottom and top thirds of the Russell 1000 Index, sorted by price/book ratios and reconstituted monthly.
Why not simply examine the Russell-style indices? Arguably, the indexes do a good job of representing active managers’ security selection. But that doesn’t make them ideal representations of the style factors themselves. Roughly 30% of Russell 1000 Index constituents appear in both the growth and value indexes, while the remaining 70% are classified exclusively as growth or value.
In our view, a stock thought to represent a style factor should, for analytical purposes at least, represent only one style. In our model, a company can be deemed only value or growth in any given month, though its classification may vary from month to month.
It’s well known that asset prices can stray meaningfully from perceived fair values for extended periods. So why should investors expect value to outpace growth in the years ahead? For one, we believe the growth trade is overdone.
Our research found that deviations from fair value and future relative returns share an inverse and statistically significant relationship over five- and ten-year periods. The relationship is an affirmation that, ultimately, valuations matter—the price we pay influences our return. That’s intuitive, right? So, too, is the imperfection of our model: While it reveals a relationship between fair-value deviations and future results, its predictions for relative performance are imprecise. That’s consistent with investment risk enabling but not guaranteeing potential returns. Put another way, if valuations perfectly presaged performance, there’d be no risk. Fortunately, that’s not how markets work.
Notes: The valuation ratio is projected based on a vector error correction model (VECM) describing the statistical relationship between cointegrated time series.
Value and growth are represented by a market-capitalisation-weighted index of companies in the bottom and top thirds of the Russell 1000 Index, sorted by price/book ratios and reconstituted monthly. Data are as at February 2021 for the period January 1979 to February 2021.
Sources: Vanguard calculations, based on data from FactSet.
The large current deviation of growth-stock valuations relative to our fair-value estimates also helps make our case. The size of the deviation is similar to the one at the height of the dot-com bubble. When the bubble popped, value proceeded to outperform growth by 16%, annualised, over the next five years3. We can’t be certain that growth stocks represent a bubble, but Vanguard’s global chief economist, Joe Davis, recently wrote about the pitfalls of low-quality growth stocks.
We believe that cyclical value-growth rotations are rooted in investor behaviour and that investors become more price-conscious when profit growth is abundant. Since 2008, corporate profit growth has been insufficient to sustain value stocks.
Vanguard expects inflation to normalise and eventually exceed the Federal Reserve’s 2% target this year and next. Corporate profits should strengthen amid economic recovery from the pandemic. Still, their impact on the “fair value of value” may be modest. The ultimate driver of the coming rotation to value stocks, then, is apt to be a change in investors’ appetite for risk.
Investors who maintain a portfolio diversified across sectors and styles can expect value’s outperformance to be a cushion against possible negative returns in the growth portion. In that sense, they would be advised to stay the course.
1 For example, as at 27 April 2021, the Russell 1000 Value Index had returned 15.51% year-to-date, while the Russell 1000 Growth Index returned 8.65%. Past performance is not a reliable indicator of future returns.
2 A short sale occurs when an investor borrows and then sells a stock in anticipation of its price declining. If the price does decline, the investor can repurchase the shares to return them to the lender at a lower price, thereby profiting. If the price rises, however, losses ensue. Regulations limit short sales.
3 Value and growth are represented by a market-capitalisation-weighted index of companies in the bottom and top thirds of the Russell 1000 Index, sorted by price/book ratios and reconstituted monthly.
Source: Vanguard calculations using data from from 1 March 2000 to 28 February 2005.
Past performance is not a reliable indicator of future returns.
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The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future returns
Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
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