By Matthew B. Fahey, Gregory S. Dirkse, Brian J. Janowski, portfolio managers for BMO Global Asset Management's small-cap and mid-cap value strategies
Growth-style investing has outperformed value by a wide margin over a majority of the last decade. Similar periods of style-based outperformance are quite common throughout the history of the U.S. stock market, but growth's extended dominance of its rival should prompt investors today to ask a couple of questions: How far along are we in this growth investing cycle? Is growth's outperformance over value likely to reverse?
Growth's multiyear cycle is stretched
An examination of the historical cycles of value versus growth suggests the market may be nearing the limit of the current growth cycle. A hypothetical portfolio created by Kenneth R. French, which shows the relative performance of U.S. value stocks minus growth stocks (defined as high book-to-market ratio minus low book-to-market ratio), provides useful data for analysis of value-growth cycles. The graph below shows the annualized five-year rolling performance of this hypothetical portfolio, called the HML (High Minus Low) line or the Value Premium. When the line increases, value is outperforming growth, and vice versa.
The graph shows that growth has outperformed value for approximately ten years now. Only one other cycle in the past 70 years has had a longer duration. It is also interesting to note that the average five-year rolling Value Premium is 4.7%, which verifies that value has outperformed growth over the long term.
So what does this mean for investors today? The graph shows five instances in which the Value Premium fell below one standard deviation of its long-term average. After each occurrence, value came back with a vengeance and dramatically outperformed growth over the subsequent years. The following table shows the cumulative return of the Value Premium when this style reversion occurs.
Since the latest trough of the Premium at -5% in April 2012, we have not yet experienced a strong value resurgence. As a result, valuation spreads between growth and value stocks have remained historically wide (i.e., growth stocks are trading at a larger valuation premium to value stocks than they historically do). Historically, this phenomenon has always reverted to the mean, suggesting value will likely outperform going forward.
Cyclicals outperform as the economy improves
The fear of slowing economic growth has led investors to rotate out of cyclical stocks and into companies whose earnings are less reliant on the overall economy. This shift away from cyclical names has dramatically helped growth over the last few years. On average, the Russell 3000 Growth Index has held a roughly 20% underweight in cyclical securities compared to the Russell 3000 Value Index.
As the economy continues to expand, investors are likely to grow increasingly confident in the recovery. This should cause cyclical stocks to respond and drive value to outperform once again.
Source: Morningstar Direct
Rising interest rates transform value headwinds into tailwinds
The quantitative easing programs implemented by global central banks have also been a key driver of growth investing's outperformance for much of the last decade. As global growth slowed, central banks adopted these programs, which included lowering interest rates, to promote growth. During slow-growth periods, it is difficult to find companies that can grow earnings, so investors pay a large premium for companies that are able to accomplish this task. Although there are many factors at play, interest rates and value/growth cycles have tended to be correlated in recent years. If global growth accelerates, interest rates should eventually follow, which would bolster the already compelling case for a value strategy.
Source: Morningstar Direct and Board of Governors of the Federal Reserve System (US)
How can investors capitalize?
We believe the historically extended growth cycle, an improving economy, and the possibility of rising interest rates all suggest it is prudent for investors to tilt their investment allocations toward value.
Some investors might be tempted to use an index fund to increase their value weighting, but we would highlight an important caveat. While the data shown in the previous two graphs represent a broad range of equity capitalizations, we see a specific opportunity in the small- and mid-cap classes. Small- and mid-cap value indexes tend to have high weightings in both real-estate investment trusts (REITs) and utilities. For example, the Russell 2000 Value Index is comprised of 16% REITs and 8% utilities, while the Russell Midcap Value Index weightings are 15% and 13%, respectively. This is important because these two sectors tend to underperform when interest rates rise. Given both sectors' historically expensive valuations, we believe they are even more likely to do so this time.
We suggest investors consider actively managed mid-cap value and small-cap value strategies for this tactical allocation, in part because the current environment highlights an advantage of active management. At BMO Global Asset Management, our portfolio managers are currently underweight the expensive REIT and utilities sectors, which we believe will underperform as interest rates rise. Over the long term, our consistent and fundamentally driven-value investing philosophy and process have delivered strong relative results for our investors.
Disclosure: I/we 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.