Mind the Valuation Gap

July 25, 2019

Growth has continued to outperform value in 2019, continuing what has become a decade long trend. For the year, growth stocks have outperformed value stocks 25.7% to 18.1%*. Going back 10 years, growth has outperformed value 16.5% to 13.2%* on an annualized basis (*as of July 15, 2019 using the Russell 1000 Growth and Russell 1000 Value indices, respectively).

During this time, the gap in valuations, as represented to the trailing price to earnings ratio has grown to historic heights, rising to the greatest gap since data was available in 1952.

Trailing P/E Ratios of US Value and Growth Stocks

Source: Kenneth R. French Data Library. Data From 1/1/1951 to 12/31/2018. US Growth Stocks refers to the “Low” 30% Fama-French Earnings/Price portfolio; US Value stock refer to “high” 30% Fama-French Earnings/Price Portfolio. The portfolios were constructed from a universe of NYSE, AMEX and NASDAQ stocks. See Kenneth R. French Data Library for further details. Earnings/Price ratios were inverted to show Price/Earnings ratios. Spread is the difference between the Value and Growth Earnings/Price ratio. Past performance is no guarantee of future results.

Where to go from here?

What are the implications of this historically wide valuation gap? The two previous historical highs, in the 1970’s and again preceding the dot com bubble, led to very significant out performance by value. In the period 1972 to 1980, value outperformed growth 13.6% to 6.3% annualized. From 1999 to 2009, value outperformed 7.8% to -1.2%.

Spread of Trailing P/E Ratios Between US Value and Growth Stocks

Source: Kenneth R. French Data Library. Data From 1/1/1951 to 12/31/2018. US Growth Stocks refers to the “Low” 30% Fama-French Earnings/Price portfolio; US Value stock refer to “high” 30% Fama-French Earnings/Price Portfolio. The portfolios were constructed from a universe of NYSE, AMEX and NASDAQ stocks. See Kenneth R. French Data Library for further details. Earnings/Price ratios were inverted to show Price/Earnings ratios. Spread is the difference between the Value and Growth Earnings/Price ratio. Past performance is no guarantee of future results.

These charts are a great illustration of the following two important concepts in a successful investment strategy:

1. Valuation Matters

For a long-term investor, valuations will drive long-term returns. In the short-run, valuations and returns can act in baffling ways, but over the long-run these normalize. In the case of growth and value, when growth becomes too pricey, the trend eventually reverses, and valuations narrow and normalize. This typically results in outsized value returns, as seen in the chart above.

2. Discipline Counts Too

Even great investment strategies will be out of favor at times, sometimes for even a very long time. This can try an investor’s patience and lure him or her away from sticking with a winning strategy. The seemingly guaranteed, outsized returns from any company with dot com in the name lured many investors away from a more disciplined approach, and most paid for their lack of discipline during the stock market crash at the dawn of the 21st century. In contrast, investors who stuck with value throughout were rewarded with substantial outperformance.

What does this mean for Investors?

Investors should remain confident in value. Even though value is underperforming growth over the last 10 years, the return of value actually looks like it’s quite good and normal versus history.  The outlier of this last decade is in fact growth, not value.  History indicates that the historically wide valuation gap between growth and value will narrow, and when that happens, strong returns for value investors follow.

 

Russell 1000 Value TR USD The Russell 1000 Value Index measures the performance of value stocks drawn from Russell 1000 index. The complete market capitalization of Russell 1000 index is divided into growth and value segments by using three factors: price to book ratio, forecasted growth and sales per share growth. The index is market capitalization weighted.

Russell 1000 Growth TR USD The Russell 1000 Growth Index measures the performance of growth stocks drawn from Russell 1000 index. The complete market capitalization of Russell 1000 index is divided into growth and value segments by using three factors: price to book ratio, forecasted growth and sales per share growth. The index is market capitalization weighted.

Past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk.  Future performance of any investment or wealth management strategy, including those recommended by Balasa Dinverno Foltz LLC (BDF), may not be profitable, suitable for you, prove successful or equal historical indices.  Historical indices do not reflect the deduction of transaction, custodial or investment management fees, which would diminish results.  Any historical index performance figures are for comparison purposes only and client account holdings will not directly correspond to any such data.  BDF clients must, in writing, advise BDF of personal, financial or investment objective changes and any restrictions desired on BDF’s services so that BDF may re-evaluate its previous recommendations and adjust its investment advisory services.  BDF’s current written disclosure statement discussing advisory services and fees is available for review at www.BDFLLC.com or upon request.

Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from BDF.