RBP Probabilities: Value Stocks vs. Growth Stocks

Since the market bottomed in March the RBP Probabilities of value stocks have been noticeably lower than those of growth stocks or the market in general. For instance, currently the DJ RBP US Large-Cap Growth Leading 30 has a weighted average RBP Probability of 90.21%, while the DJ RBP US Large-Cap Value Leading 30 has a weighted average RBP Probability of only 78.07%. What causes this discrepancy? It is an interesting phenomenon and one that I have thought much about.

Before I get started, let us define value stocks and growth stocks. The components of DJ RBP Growth Indexes are drawn from the Dow Jones U.S. Large-Cap Growth Index, whereas the the components of DJ RBP Value Indexes are drawn from the Dow Jones U.S. Large-Cap Value Index. Half of the stocks in the Dow Jones U.S. Large-Cap Index are designated growth and half value based on a “style” score that is calculated from six variables: Projected PE, projected earnings growth, price-to-book, dividend yield, trailing revenue growth and trailing earnings growth.

It is interesting to divide the universe in to these two categories because RBP Probability itself is determined primarily by a) growth and b) price. So if a high growth company also has a high price (and would thus be unequivocally classified as “growth” by Dow Jones) it can have a high RBP Probability provided the price is fully justified by the growth the company has experienced. Similarly, a low growth company with a low price (“value” stock) can also have a decent RBP Probability simply because the low price does not imply much growth.

With this in mind, we can see that both growth and value stocks should have similar RBP Probabilities if valuations are in balance and are reasonable relative to one another. But today, they are not. For some reason value companies simply seem to be either overpriced or underperforming operationally. Notice that I am not concerned with the overall level of the market – we could argue about whether this year’s 50% market rally is justified but that is not relevant to the discrepancy between growth and value.

The performance of value versus growth stocks since March can’t explain the discrepancy. From March 8 to present, the Dow Jones U.S. Large-Cap Growth Index has returned 53.49% while the Value index has returned 53.93% - amazingly similar results.

So, given that valuations of the growth and value indexes have changed in lockstep, I am drawn to the performance of the component companies to explain the discrepancy in RBP Probabilities. Value has been preferred over growth for many years now, but recently growth has returned to favor – at least according to many Wall Street pundits. I can’t find any hard evidence that this is true, but the theory is logical: In a beat-up economy where the government is doing everything it can to stimulate economic growth, it stands to reason that the faster growing companies would benefit first since it is, after all, growth (and not the correction of undervaluation) that the government is after.

For example, two major targets of stimulus spending – broadband communication and clean energy – are industries with fast growing, high multiple companies. And it would seem that by providing stimulus funds, Obama is aiming to kickstart emerging technologies, not nurture old ones.

So if growth is favored, yet growth and value stocks are both rising at the same rate, this means that value stocks must be rising at a rate disproportionately higher than their business growth. And when prices rise faster than business performance, RBP Probabilities decline.

From this I conclude that, as long as government stimulus continues, value stocks are not a good buy right now. The market seems to be assigning them unjustifiable valuations that are predicated on governmental stimulus spending, yet such spending by its very nature helps growth stocks more than value stocks. Having said that, if and when this stimulus ends, growth stocks may appear overvalued.