Value stocks should be over emphasized in your holdings of US stocks both because of their historical averages and the current economic climate. Value stocks are those that have a lower-than-average price as measured by such metrics as price-to-earnings or price-to-book ratios.
Value investing is often considered the opposite of growth investing, which concentrates on finding companies with above-average sales and earnings growth prospects. The price of growth stocks is usually justified on the basis of a track record of high growth. If the company keeps growing then the stock price is worth it.
The hope is that you have purchased the next Microsoft, discovered the next Amazon.com, or found the Cisco that makes the Internet run.
Growth stocks have higher prices on the anticipation that their steep growth rates can be maintained. If they failed to meet expectations, their share price drops quickly even if the company is still experiencing growth. Stock prices based on 40% year over year growth can’t be justified if the growth will only be 20%.
Investors are encouraged in this optimism by their own greed and pride as well as the Wall Street brokers and analysts who earn their living mostly by speculators looking for the next hot investment. Growth stocks are expected to have high growth rates, but only about one in three grows more than 10% each year for five years and only about one in five grows by at least 15% each year.
Value stocks easily beat growth stocks during bear markets or when the economy is doing poorly. When the economic forecast turns cloudy the stocks whose price was based on clear skies and stellar growth fall the most.
|Annualized Returns||One Yr.||Three Yrs.||Five Yrs.||Ten Yrs.|
|Russell 1000 Value||16.5%||8.6%||5.3%||13.8%|
|Russell 1000 Growth||6.3%||-0.2%||-9.3%||9.6%|
|Russell Midcap Value||23.7%||15.6%||13.5%||15.7%|
|Russell Midcap Growth||15.5%||6.2%||-3.4%||11.2%|
|Russell 2000 Value||22.3%||16.5%||17.2%||15.2%|
|Russell 2000 Growth||14.3%||5.8%||-3.6%||7.1%|
|Returns annualized through Dec. 31, 2004. Source: Frank Russell Company|
As you can see from the chart, the Russell 1000 Growth is the category that has had the poorest performance during the past five years. During the last half of the 1990’s this category was increasingly flooded with over-priced technology stocks in general and Internet stocks in particular.
Today, technology and healthcare stocks comprise 46% of the Russell 1000 Growth. With the current environment of the US markets, technology stocks may not perform as well as they might at a different time. Historically stocks have averaged a P/E ratio of about 14. Currently, the Russell 1000 Growth has a Price/Earnings ratio of 22.13 while the Russell 1000 value is at 15.52.
The same company can be considered a value stock when its price is low and a growth stock when its price is high. Since the distinction between value and growth is dependent upon a stock’s price, the same stock is a better buy and will appreciate more when they are considered value stocks. Some growth stocks are merely value stocks that have become over valued.
Value stocks pay better dividends. At the end of last year the Russell 1000 Value was paying 2.3% in dividends while the Russell 1000 Growth was only paying a 1% dividend yield. The difference is even greater for mid and small cap stocks. Dividends can account for a large percentage of the total return.
Our philosophy is to overweight those investments where the average return is higher and the average risk is lower. We consider such decisions a win-win situation. The beta of the Russell 1000 Value is only 0.93 while the Russell 1000 Growth is 1.05. Getting a higher average return for less risk is always a good decision.
Given all the advantages of value over growth, you might ask why you should invest in growth at all. The answer is diversification.
Value stocks do much better than growth stocks during bad times. In flat markets they still slightly outperform growth stocks. But these are just averages. There are times – such as the last half of the 1990s – when growth is the place to be, and you don’t want to miss the returns that growth can offer. Having some exposure to growth can provide a more diversified asset allocation, and therefore smoother overall returns.
Over weighting value stocks is only one small part of an asset allocation designed to reduce average risk and increase average returns and should be used as part of a balanced portfolio investment policy.
Photo by Sebastián León Prado on Unsplash