FROM BARRON'S | NOVEMBER 2, 2017
Growth versus value. For many years, that was one of the central debates for investors, analysts, managers, and financial advisors. Growth and value stocks seemed to be the yin and yang of stock investing, with radically different characteristics that attracted investors with different temperaments.
Growth is defined as companies measured on the strength of their earnings; value is defined as companies measured on the price of their stock relative to underlying assets. That is a simplistic distillation, but even that has faded in the past few years. Instead, the focus has been on larger questions of whether stocks overall are too dear, bonds still attractive, and markets stable.
This year so far, however, suggests that investors would do well to revisit the question of growth versus value, as well as the related conundrum of active versus passive, because the spread in how these various categories have performed has been quite dramatic, with wide differences in how investments have performed. If, going forward, returns are less correlated—that is, if stocks and bonds don’t rise and fall en masse but instead result in large differences between individual stocks and bonds and among specific allocations—then questions like growth versus value will rise to the fore once again.
At the end of the day, or year, growth is likely to do quite well provided investors believe that the future has something to offer; value is often the abode of those more skeptical about promises of future innovations and change. If you believe that the future might be bright for select parts of the economy, then growth stocks merit your focus.
Growth versus value redux
Investing clichés are common. Some are wise, but are easy to implement only in hindsight: “Buy high. Sell low.” Some are true only when they are true: “Markets climb a wall of worry.” Some are relatively useless, “Buy the rumor. Sell the news.” A few, however, can have some virtue: “When the herd goes one way, you go another.” Well, this year the herd has been yanking money out of actively managed funds and pouring into ETFs and passive vehicles.
With stock markets up decently and bond markets offering little drama, few have been complaining about their returns. But for the first three quarters of this year, growth stocks have substantially outperformed value stocks. Through mid-October, the Russell 1000 Growth Index was up more than 22% compared to the Russell 1000 Value Index which was up barely more than 9%. The picture for smaller capitalization names was no different, with the Russell 2000 Growth Index up about 18% compared to value up about 7%.
Active stock funds have also been strong. After some significant struggles relative to their benchmarks over the past years, active growth funds have had stellar performance compared to passive funds that mirror the entire market. According to data from Morningstar, nearly 60% of active large growth managers outperformed their relative index though September.
One reason for the outperformance of large-sized growth companies, whether in passive or active funds, has been the weighting of technology giants, such as Google parent Alphabet (ticker: GOOGL), Amazon.com (AMZN), Facebook (FB), Netflix (NFLX), Apple (AAPL) and down the list. A good deal of skepticism remains about these markets, and many people are uncomfortable with the continued rise of stocks in general and valuations of some of the names that have propelled this multiyear rally. A recent headline stated baldly: “Why rising optimism should make stock-market investors nervous!” That was hardly an outlier.
Of course, forgotten in that mix are the various times over the past few years when stocks have pulled back sharply, including technology names, as they did in early 2016. In the first month and a half of 2016, the tech-heavy Nasdaq was off nearly 15%.
So, it’s not as though tech stocks—let alone stocks in general—have been only up over the past years. This year has certainly had incredibly low volatility and a steady melt upwards of stocks, as well as low volatility for most bonds. The absence of volatility has calmed some, but it has also spooked others who see it not as stability but the proverbial calm before the storm. Seen through that lens, each day stocks do okay is one day closer to the day when they do not. That may, of course, prove to be the correct lens. Pullbacks and crashes happen, and they usually take most people by surprise.
Growth stocks demand that investors have some real confidence in the future. Indeed, one thing that has long separated growth investors from value investors is temperament. Value investors have been seen as more conservative, more cautious, more aware of the vagaries that can quickly undermine the hot new name and the sexy new trend. Growth investors have been seen as flashier, more risk-prone, more focused on what could be than on what is. After all, you don’t invest in a company growing quickly and innovating and disrupting if you don’t believe that the future might be rosy and reward those who take risks.
Today, however, even as some companies are doing spectacularly, the general mood is caution. According to regular polls by Gallup, most Americans see the country as a whole as being on the wrong track and are not confident that the world their children will inherit will be better than the present. You can’t draw a specific line from those attitudes to the lack of enthusiasm for growth stocks, but that lack is evident from fund flows, which continue to see investors pouring money out of domestic U.S. equity and into fixed income.
Add to that a general distaste for active investing. Index investors can capture much of the growth stock story, but this year many active funds have captured even more of it. Those funds can take even larger positions in high-conviction companies, as opposed to an index fund, which has fixed weightings (albeit periodically rebalanced). This year has been a good one for skilled active stockpickers, but that follows a rough few years, which may explain why so many investors have been reluctant to put money with active managers, let alone with growth managers, and let alone with stocks. In order of confidence about the future and willingness to take risk, active growth managers are further along the curve. Yes, investors who pile into “safe,” low-yielding fixed income are taking risks that their portfolios will not live up to retirement needs and expectations; psychologically, however, in uncertain times, the knee-jerk tendency is to default to what has been safe in the past, whether or not that is the most prudent decision going forward.
And so, we have a year that has rewarded many active growth managers and anyone who has invested in growth stocks, passive or active. Given fund flows and sentiment, it is also a year that many people have missed. If investing clichés hold, it may be that more investors will turn to growth stocks going forward in light of how well they have done, which might be precisely when that outperformance fades. Who knows? But if the economy maintains its steady trajectory, the growth stocks that have powered returns this year are likely to do well for some time to come.