There is a continual tussle between growth and value investors about which approach is superior. Standard and Poor's constructs indices based on both styles, and examining the data we can gauge historical relative performance and insights into which approach might outperform in today's market. Over the last twenty years, growth investing has produced an average return (+9.30%) that is thirty two basis points higher than the average return on the value index (+8.98%). However, the lower standard deviation of annual returns of the value strategy saw it post a better Sharpe Ratio, meaning that on a risk adjusted basis the value strategy was superior.
In today's market environment, I would expect growth strategies to outperform. Growth, after all, is what this economic recovery is lacking. Investors may "pay" for growth, bidding up the prices of stocks that are growing top and bottom line results at a greater rate than the market. The S&P 500 Growth Index is currently trading at 16.1x trailing twelve month earnings, which is roughly 80% of its trailing twenty year average earnings multiple of 20.2x. The S&P 500 Value Index is trading at 12.6x, which is roughly 82% of its trailing twenty year average of 15.4x. With both indices valued roughly equivalently to their historical multiples, I expect growth to outperform as these companies grow the denominator in P/E relatively quicker.
Over the last twenty years, the tradeoff between value and growth has been surprisingly cyclical. In the recovery from the 1991 recession, value outperformed. In the lead-up to the tech bubble, growth was rewarded. In the messy aftermath of the bursting of the tech bubble, value came back into favor. Through the Great Recession growth stocks have again outperformed.
Given the persistency of outperformance by one investing style, a momentum strategy could have merit. If an investor were to purchase the index of the style that performed best in the past year, and then hold for one year forward, this strategy strongly outperformed both growth and value investing on average over the past twenty years. This momentum strategy is readily transactable as the S&P Value Index is replicated through the iShares S&P 500 Value Index Fund (IVE), and the S&P Growth Index is replicated through the iShares S&P 500 Growth Index Fund (IVW). The momentum strategy's average return of 11.05% outperformed the growth strategy by 175 basis points and the value strategy by 207 basis points. While the momentum strategy produced a more variable return profile, the excess return generated still made the momentum strategy superior on a risk-adjusted basis.
With growth companies trading at a normal historic relationship to value companies, I expect growth stocks to marginally outperform value stocks in this low growth economic recovery. Even if multiples stayed constant, increasing earnings in growth stocks should boost their value quicker than slower growth value stocks. Do not be surprised to also see multiple expansion in growth stocks outpace that of value stocks as investors buy growth in this slow economic expansion. While the momentum hypothesis is an interesting observation, I do not view it as a meritorious trading strategy without further study across longer time periods and markets. I offer it here as only a support to the relative outperformance of growth stocks over the remainder of 2012.