Cheaper isn’t cheap enough
Value will probably beat growth in the years ahead, but that won’t necessarily mean high returns
“Value versus growth” is one of the easiest frames through which we can look at investing styles. Yes, it is a simplistic divide (see below): no investor can ignore valuations nor how earnings are likely to evolve. But it still says something about the psychology of an investor: do you favour a solid chance of profits today or the riskier possibility of a bigger gain in the future?
Splitting markets into growth and value also shines a useful light on trends. The MSCI World Growth index has beaten its value counterpart by six percentage points per year over the past decade, which is remarkable, but by more than sixteen points per year over the past three years, which is barely believable. With the growth index now on a forecast price/earnings of almost 30, compared with 13 for value, it’s hard to see how that can be repeated.
Investors want excitement
Value against growth is not the only long-standing anomaly to struggle lately. History also suggests that stocks with lower share-price volatility tend to outperform more volatile ones on average, yet the S&P 500 Low Volatility index (which holds the 100 least volatile stocks in the main US benchmark) has lagged the S&P 500 by
3.5 percentage points per year over ten years and almost ten percentage points per year over the past three years. No matter how you break it down, you can see the preference for glamorous, volatile growth stocks over anything duller.
Yet neither value nor low volatility have performed badly in absolute terms. The World Value index has returned an acceptable 9%-10% per year over three, five and ten years. The S&P 500 Low Volatility has returned 15% per year over three years and 12%-13% over five to ten years. This makes it hard to be confident that we can expect value stocks or low-volatility stocks to do well in absolute terms when the environment changes, because in many cases they have not done worse than expected up to now – they’ve simply been outstripped by a boom in growth.
In particular, much of the return from value stocks usually comes from improving valuations as investors become less negative about their prospects, not through growth or increased profitability (see the chart above from Verdad Capital, which shows that about two-thirds of the total return in US value over the last 25 years came from changes in valuations). Today, value is not especially cheap in absolute terms, even if it is relatively cheap compared with growth. That will make it harder to benefit from the tailwind of improving valuations. Thus while value – and low volatility – will probably do better relative to growth, only a few genuinely unloved sectors (perhaps oil – see right) seem likely to deliver impressive absolute returns.
“Neither value nor low volatility have done badly”