Proof in the performance
Nevertheless, despite the different methodologies, the results are similar. Both MSCI’s and Russell’s value indices have outperformed their growth counterparts over the longer term and with lower volatility, but both have underperformed in recent years.
Explanations for this outperformance tend to fall into two categories: risk-based and behaviour-based. The risk-based explanation is that value stocks are lowly valued because there is something wrong with the underlying company, meaning they pose a higher risk. The behavioural explanation, on the other hand, is that they are lowly valued because investors have become pessimistic.
I side with the behaviourists. If value stocks are higher risk, why is their volatility lower? I would be first to assert that volatility is an imperfect measure of risk but, if value stocks are higher risk than growth stocks, one would expect their volatility to be higher. The volatility of the Russell 1000 Value Index has been 16.5% since inception in December 1978, compared with 19.9% for its growth index.
The behavioural explanation makes much more sense. Investor herding is a real phenomenon and it can move a stock well below its intrinsic value. From this point, the more likely direction is up.
As for growth, there are similarly defined explanations. Growth stocks underperform either because they are low risk or because investors put too much faith in a company’s growth prospects. I think you can guess which side I am on.
The reality is that it is a lot harder than many think for a company to make decent returns on investment. The excitement can often turn to disappointment as investment intended to reap rewards goes down the toilet. This all helps to explain why growth has been outperforming value in recent years.
With interest rates stuck at low levels and labour markets generally loose, it has been harder for companies to disappoint.
This has meant companies that would struggle in a more competitive environment have found it easier to survive and even thrive, allowing investors to continue to drink the Kool-Aid. Value stocks have not been doing badly but they haven’t done as well as their growth counterparts.
Therefore, the question of whether value will start to outperform really comes down to when the corporate landscape will become more competitive, either because interest rates start going up or labour markets begin to tighten – they normally go hand in hand.
