Since last September, value stocks have outperformed their growth counterparts after a decade of disappointment. Vanguard thinks the trend has just begun.
“Over the last 10 years growth has outperformed value by an average [of] 7.8% per year,” Vanguard researchers wrote in a paper released yesterday. The depth and persistence of “value’s underperformance is striking,” they said.
The paper attempts to explain this “atypical” phenomenon by constructing a fair value model for the ratio of value to growth stocks, which it calls value/growth. The paper was authored by Kevin DiCiurcio, Olga Lepigina, Ian Kresnak, and chief economist and head of global asset allocation Joseph Davis.
Vanguard now expects value to beat growth by 5% to 7% over the next decade. That outperformance gap could be as wide as 9% to 13% over the next five years. How this all plays out holds particular importance for financial advisors and their retired clients, many of whom have favored dividend-paying value stocks only to be disappointed as a result.
Some academic observers have sought to attribute this behavioral result to factors like the slow growth, low inflation and interest rates that have characterized the past decade. All three indicators are extremely low compared to their historical levels. That’s one explanation of why investors have willing to pay a premium for growth, that argument maintains.
Vanguard’s researchers acknowledge there is a degree of truth to that narrative. But it’s a story that has been “oversold,” in their views.
Another theory they cite is the “winner-take-all” advantages of some giant technology companies. Again, Vanguard concedes this argument has merits it’s not the dominant factor.
Instead, the four dominant drivers are the corporate profits growth rate, stock market volatility, real interest rates and inflation, the giant asset manager argues.
Vanguard also attaches some weight to adjusting book value metrics to include R&D expenses and intangibles, as asset-light businesses are an increasingly powerful force in the U.S. economy. This is a concept first put forth by Research Affiliates co-founder Rob Arnott. “That driver—which has increased 550% since June 2011—explains most of the 80% run-up in the ratio of growth to the broad market,” the paper declares. But when all the other variables are combined, the significance of R&D expenditures declines, the authors add.
Part of the performance gap stems from the stunning outperformance of growth. In other words, value stocks as a group have not underperformed historical norms by a huge degree; they’ve just lagged growth’s spectacular run.
Also, value stocks far “more sensitive to cyclical drivers such as market volatility and corporate profits than are growth stocks,” the paper says. Moreover, growth and value “appear to be at the upper and lower bounds of their respective fair value to market value estimates.” Finally, the secular decline in inflation “over the past 40 years explains a majority of the decline in the fair of value/growth since 1979.”