By: Richard Feldman
By: Richard Feldman, CFP, AIF, MBA
Value investing has blown the doors off of growth investing over the last seven years. Value stocks have bested growth stocks every year since 2000 as measured by the Russell 1000 and six out of the last seven years for the Russell 2000. The one year the Russell 2000 growth index did perform better was 2003 when it was up 48.53% versus 46.02% for the Russell value index. What will the future bring for these two different investment strategies?
Value Investing versus Growth Investing
A manager’s style or index style is a reflection of their fundamental approach to investing in the equities markets. Value managers believe that stocks can trade below their intrinsic value for multiple underlying reasons and try to purchase a security when the stock is unfashionable or out of favor. Growth managers typically purchase securities that will provide superior investment returns based on the future growth of earnings of the company and not necessarily the current share price. Typically an index will be subdivided into value and growth subsets based on standard value measures such as price/earnings, price/book, or book/market ratios and define the lower priced half as “value stocks” and the higher priced or more expensive stocks as “growth stocks”
Large Cap Equity Returns
Looking at the long term returns of the Russell 1000 index which is a proxy for large cap domestic equities you will see that large cap value stocks have a much tighter distribution of returns than large cap growth stocks.
The chart above shows the annual returns of the Russell 1000 Value and Growth Indexes from 1979 – 2006. The average annual return for the Russell 1000 Value Index was 15.40% and the average annual return for the Russell 1000 growth index was 13.65%. A portfolio’s volatility is typically measured in terms of standard deviation and as you can see from the chart above the volatility of returns is wider for the Russell 1000 growth index. The chart translates into a standard deviation for the Russell 1000 value of 13.55% and 19.62% for the Russell 1000 growth. Volatility of returns has a direct impact on terminal wealth accumulation. The higher the volatility of returns the less terminal wealth you will build in a portfolio.
Small Cap equity Returns
Now you might assume that this phenomenon only happens in large cap domestic equities but the data is consistent in both large and small stocks both domestic and international. Let’s take a look at the returns of the Russell 2000 index which is a proxy for small cap equities domestically.
Again you can see from the chart above that the distribution of returns is much tighter for the Russell 2000 value index than the Russell 1000 growth index. The annual average return for the Russell 2000 value and growth index is 17.23% and 12.65% respectively. Again you will notice from the chart above that the distribution of returns for the value stocks of the Russell 2000 is tighter which leads to a standard deviation of 17.26% versus 23.14% for growth stocks.
When developing an investment policy for a portfolio one must allocate between value and growth asset classes. We allocate percentages based on the findings of Eugene Fama and Ken French and the efficient market hypothesis that high price to book stocks tend to have a higher expected return because they are riskier. Over weighting value stocks in a portfolio can lead to higher expected returns and lower volatility. In so doing you must be prepared that you will have long stretches of time where growth outperforms value like we had in the late 90s and vice versa which we are currently enjoying since the year 2000.