History shows that value usually wins out
by Gregg S. FisherMr. Fisher is the founder of Gerstein Fisher, a New York based investment management and advisory firm established in 1993. Visit gersteinfisher.com. Reprinted with permission.
As 2015 draws to a close, many investors are studying their portfolios and ruminating over appropriate allocations for 2016.
One key decision is how much to allocate to growth stocks, and how much to give to value stocks. In this calculation, investors may be confused by the apparent contradiction between recent and long-term market history.
For instance, from January 2009 to November 2015, growth (as measured by the Russell 1000 Growth Index) has trounced value (Russell 1000 Value Index), returning 17.6% annualized versus 13.6%. Yet, I believe that lurking in the backs of many investors’ minds is the memory that, over the long run, value historically has outperformed growth. Gerstein Fisher recently conducted considerable research (which I will summarize in this article) that should shed some light for investors on the growth and value choice.
Students of finance will recall the landmark paper published by Eugene Fama and Kenneth French in 1993 which demonstrated that stocks with low price-to-book ratios (aka value stocks) entailed extra risk as compared to growth stocks, and thus investors required extra compensation for holding them (i.e., risk and return are related).
The seminal Fama/French research helped to spawn an industry of quantitative equity investment strategies based on the value factor (we plead guilty here at Gerstein Fisher). As Exhibit 1 clearly shows, over a nearly 90-year period of market history, an investor would have been richly rewarded for investing only in value stocks.
But let’s look up from the historical data for a second and ask ourselves some practical questions: unless you are the Harvard Endowment or the Rockefeller Foundation, who has a 90-year investment horizon? Moreover, since investors are humans (and not “Econs”, as behavioral finance professor Richard Thaler calls it in his recent book, Misbehaving), they are afflicted with emotions like fear and greed and biases such as recency bias, or the engrained habit of extrapolating recent outcomes into the future.
What if a mere mortal is invested in an all-value portfolio and, while chatting at a cocktail party or working out at the health club, overhears fellow homo sapiens boasting about his superior returns in growth stocks (after all, growth has outperformed value for nine years now)? Quite likely he or she (I don’t say it because computers and robots are akin to Richard Thaler’s Econs) will question the all-value strategy, turn green with envy, and start selling value stocks and loading up on growth. In fact, our research shows that investment-style cycles are pronounced (incidentally, that is why we construct multi-factor and not single-factor quantitative equity funds) and that investor attempts to time markets and cycles are far more likely to be harmful than beneficial to long-term wealth accumulation.
Shades of Gray
But what if the decision to invest in value or growth stocks (as illustrated in Exhibit 1) is not a binary one and there is a third option: a portfolio that combines value and growth together in equal proportions? Exhibit 2 reports the results of this test during the same 90-year time frame. As you can see, the 50/50 portfolio, which hedges bets between the two investment styles, outperforms the growth-only portfolio by a wide margin and barely trails pure value.
Since, again, a 90-year investment horizon isn’t available to us mortals, we decided to look through the microscope and examine value and growth closely over numerous time periods across the 90 years with a view to analyzing how frequently one style outperforms the other and how often an investor would benefit from owning both. Exhibit 3 summarizes the results of our analysis.
For example, during one-year rolling periods, when value outperformed growth, it did so by an average of 13.6%; when growth held the upper hand over one-year stretches, it outperformed value by 11.7% on average. When the blended portfolio was added to the picture and compared to the pure portfolios we found that, when it lagged a pure portfolio, it did so by a lesser margin as compared to the other pure portfolio.
Comparing the three portfolios over short periods of time (five years or less), reveals that it is essentially a coin-toss game as to which outperforms, with an almost equal probability that any of these is the winner. Here are some additional highlights from our study:
When comparing the Value and 50/50 portfolios for the periods in which the 50/50 portfolio is not the winner, its underperformance as compared to Value is significantly lower than Growth’s underperformance as compared to Value.
The same holds when Growth and 50/50 are analyzed. It is a coin-toss game, and when the 50/50 portfolio underperforms Growth it does so by less than Value.
Over long investment periods (10 years or more), clear winners emerge and different “pure” portfolios (Value only or Growth only) outperform in different regimes; it is no longer a coin-toss game. To wit:
- July 1926 to 1944: Growth wins
- 1945 to 1962: Value wins
- 1963 to 1980: Value wins
- 1981 to 1998: Value wins
- 1999 to July 2015: Growth wins
Over extremely long investment periods (e.g., 50 years or longer), a Value-only strategy would be a sound investment. Over shorter periods, however, it’s not as clear which of the three approaches will win out, but our analysis shows that blending Growth and Value even in a simple 50/50 split generally offers returns more stable than either a 100% Value or 100% Growth portfolio. Since investors who hold either pure-Growth or pure-Value portfolios have to contend with the inevitable swings of their investment style going in and out of favor, a diversified approach that blends the two styles would appear to be a superior approach for both empirical and behavioral reasons.
 Fama, Eugene F., and Kenneth R. French, “Common Risk Factors in the Returns of Bonds and Stocks, 1993, Journal of Financial Economics.
 As with Exhibits 1 and 2, for our value, growth and blended portfolios, we used the Fama French Large Growth (ex Utilities) Index, the Fama French Large Growth (ex Utilities) Index, and a 50/50 mix of both.