The Equity Growth Value Paradigm, Part I: What It Is Not

by: Newfound Research

Ask ten pundits "why it's important to invest in a balance of growth and value" and you're likely to get similar answers:

  1. Value tends to outperform growth as the economy slows down and falls into recession. Value stocks already have lower PE ratios and are relatively undervalued when compared to growth and therefore depreciate less.
  2. When the economy comes out of recession and begins to grow again, growth stocks capture more of the upswing because they have higher rates of earnings growth and plow back their profits.
  3. Because no one can predict when a business cycle will end and begin, it's important to have a blend of growth and value in the portfolio to both soften the fall during down times and participate in the upside during market booms.

Prima facie, the story seems plausible. If someone didn't specialize in quantitative strategy construction, he might just accept the reasoning above without a second thought. However, with some very simple graphs and a little bit of reasoning (we'll spare you the deluge of mathematics today), we'll show you why this argument hasn't held up in the past.

If The Tale Were True

The United States has experienced fifteen recessions from 1926 to the present day, so some historical analysis can be done to determine whether the "recession based" line of reasoning to describe growth / value performance disparity has held up in the past. To test recession based reasoning, we examine the ratio of growth to value (performance information can be found on Kennenth French's Website) during times of recession and nascent expansion. If the ratio is decreasing, that means value is outperforming, whereas an increasing ratio indicates growth is outperforming. The ratio resets to 1000 for each of the periods for illustrative purposes. If the recession based logic is true, a trend similar to the following graph should be seen during times of recessions and expansions:

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The last fifteen recessions and the relative performance of growth and value are plotted below. Take a look to see if there is any resemblance to the graphic that corroborates the recession driven story of outperformance between the equity styles.

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Does historical data support the fable that value outperforms as the economy falls into recession and growth outperforms when the economy begins to recover? Not really. There are a couple instances that seem close (1953 - 1955 and 2007 - 2010), but by and large the results seem widely varied.

Summary Statistics

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If there was any semblance of consistency (or statistical validity) to the rationale of value/growth performance disparity attributable to recessions, positive mean and median values would be present on both of the graphs above. We might even expect to see the most positive values take place at the beginning of each of the graphs and slowly dissipate over time as the economy transitions from one phase of the business cycle to the next. Instead, standard deviations of the sample exceed the historical impact of choosing one equity style over the other while mean and median values frequently show differing signs of over performance. So although the recession based rationale of equity growth and value trend persistence makes intuitive sense, it simply is not supported by empirical evidence. In later posts we'll more closely examine the switching trend between growth and value and where it does come from. Because although the recession based rationale isn't supported by empirical evidence, the switching style trend most certainly exists and we believe it will continue to persist well into the future.

Business relationship disclosure: Newfound Research is a quantitative asset management firm. This article was written by Benjamin Gross, one of our Managing Directors in our Product Development & Quantitative Strategies Group. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.