Brighter days are ahead for U.S. value stocks.
This might seem a relatively safe prediction. After all, shares in U.S. companies with relatively low valuations and high dividend yields have outperformed their growth counterparts so far this year.1 And as our recent 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 skeptical. Powered by a relentless rise in technology share prices, growth stocks have handily outpaced value—the province of financial, utility, energy, and basic materials companies, among others—since the 2008 global financial crisis.
Until recently, a long-running performance premium for value
Notes: The chart displays monthly observations of ten-year annualized total returns for periods from June 1936 through January 2021 of a hypothetical long-short value versus growth portfolio constructed using Fama-French methodology, available at https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/f-f_5_factors_2x3.html. Past performance is no guarantee of future returns.
Source: Fama-French research returns, outlined at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html#Research.
What drives the relative performance of value and growth stocks?
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 behavior has played a role as well.
We expect value to outperform growth over the next ten years by five to seven percentage points, annualized, 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 and style-specific market indexes that serve as benchmarks for many real-world investment portfolios.
An explanation of our methodology
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 stocks.2 To assess the performance of investable value and growth portfolios, we constructed market-capitalization-weighted indexes 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 indexes? 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.
Why value stocks are poised to top growth stocks
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.
Fair value typically prevails over time
Notes: The valuation ratio is projected based on a Vector Error Correction Model (VECM) describing the statistical relationship between cointegrated time series. The VECM is a dynamic model of the first differences of the variables used in the cointegrating regression that includes a disequilibrium term to correct deviations from the long-term equilibrium.
Sources: Vanguard calculations, based on data from FactSet.
Asset bubbles and the investment road ahead
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%, annualized, over the next five years. 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 behavior 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 normalize 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.
For investors with sufficient risk tolerance, time horizons, and patience, an overweight to value stocks could help offset the lower broad-market returns we expect over the next decade.
1 For example, as of April 27, 2021, the Russell 1000 Value Index had returned 15.51% year-to-date, while the Russell 1000 Growth Index returned 8.65%.
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.
All investing is subject to risk, including possible loss of the money you invest.
Past performance does not guarantee future results.
There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.