The Cyclicality Of Growth

If you had observed fashion trends over the past four decades you would have seen bell bottom jeans, tapered jeans, boot-cut jeans along with those awful skinny jeans. Fashion trends go in and out style without much rhyme or reason, but what about investment trends?

Do investment styles work for a period of time and then go out of style? Is there any cyclicality to these trends?

For the past 12 years, growth stocks have outperformed value stocks by a wide margin, yet this is the opposite of what transpired between 2000 and 2007 – when value dramatically outperformed growth.

And 2000 to 2007 is the opposite of what transpired between 1994 and 2000 when the tech bubble caused growth stocks to dramatically outperform value stocks.

This sounds like a trend – a longer period of time when one style is in favor, until something new comes along, or something happens to disrupt the trend that was formerly in place. 

The disrupter in 2000 was the implosion of the tech bubble. NASDAQ peaked in March of 2000 and proceeded to drop nearly 80% of its value over the next thirty months.   

There is no clear explanation on what caused the trend to shift in 2007, but so many investors jumped onto the value band-wagon as an over-reaction to the dot.com-implosion that “value” was no longer very valuable. 

The competing relationship between growth and value is captured in the graph above comparing the Russell 1000® Value Total Market Index to the Russell 1000® Total Market Index.

The competition between growth and value is actually a relatively new phenomenon. Apart from the last twenty-five years, value stocks have consistently dominated the performance of growth stocks going all the way back to the Great Depression.   

Source: Ken French Data Library, Telos Asset Management Company 

Looking back at 90 years of data, there have only been three periods when growth stocks were a strong competitor to value stocks: the tail end of the Great Depression, the Technology Bubble of the 1990s and the past twelve years. The length and depth of the most recent run is the most extreme on record.
 
Over that 90 year window, growth (the most expensive quartile of stocks) has historically traded around 2.1 times book value while value (the cheapest quartile of stocks) has historically traded around 0.7 times book value.

Today’s valuation gap between growth and value is one of the widest on record. With today’s wide valuation gap, the odds of valuations reverting back to their mean are high.

Source: Ken French Data Library, Telos Asset Management Company 

Conclusion

Could growth stocks continue to outperform value stocks over the next few years? Yes, of course they could. But the trend will shift at some point.

That shift might come from investor fears over the high valuations of the stock market, concerns about the economy, or something that is not even on investors’ minds today. That shift will likely drive a change in investor sentiment, and the change in investor sentiment is likely to cause valuations to revert back to their mean with value stocks regaining a place of prominence.
 
It’s impossible to predict when that shift will take place, but the good news for value investors is that the odds increase as the valuation gap between growth and value widens. With the valuation gap as wide as it is today, the odds are fairly high.

The essence of value investing can be summarized by maintaining a strong conviction in three simple concepts:

1) Buy assets that are cheap relative to historical levels
2) Avoid assets that have run up in price
3) Be patient while waiting for prices to revert back to their mean over time