Significant research and media coverage have been allocated to factor exposure or “smart beta” investment strategies. The value factor, in particular, has been heralded by most proponents of factor investing as one that delivers a return premium
over the long run.
Unfortunately, recent experience has not reflected this research
. Over the 10 years ending March 31, 2016, the Russell 1000®
Growth Index has topped the Russell 1000®
Value Index by 2.6% per year (8.3% and 5.7%, respectively). In fact, that relationship has held true for the past 14 years. Investors have to reach back 15 years before the annualized returns begin to look better for value than for growth (6.4% and 6.0%, respectively).
Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.
Does this mean a changing paradigm for the growth-value relationship is occurring? Is the value premium dead and gone, or is this just another example of an investment cycle lasting longer than investors have come to expect?
We believe it is more the latter than the former for the following reasons:
- Investment cycles can by very long
- Value stocks are starting to appear cheap
Investment Cycles Can Be Very Long
Investing is not likemath; there are few, if any, proofs. In investing there is no equivalent to 2 + 2 = 4, but there are some generally accepted beliefs. One of the strongest is that stocks will outperform bonds over time. That’s because investors expect to be rewarded with greater returns for taking on the additional risk of stocks relative to bonds. However, there can be long periods when bonds beat stocks
. A recent example is the 20-year period ending February 2009, with bonds (represented by the Bloomberg U.S. Aggregate Bond Index) topping U.S. stocks (represented by the Russell 3000®
Index) with a return of 7.3% vs 7.1% annualized. That is a long period of underperformance for stocks, but it did not, and does not, negate the widely accepted belief that stocks should beat bonds over the long-run.
Similarly, having value stocks trail growth stocks over a long stretch should not deter the long-term belief about the return premium attached to value stocks. Markets have seen comparable long stretches of growth leading value in the past. For instance, growth stocks beat value stocks over 20-years ending December 1999, 17.8% vs 16.8%, according to the Russell 1000 Growth Index and Russell 1000 Value Index. Investors giving up on value stocks based on that 20-year stretch were soon disappointed by that choice
when the relationship reversed.
Value stocks are starting to appear cheap relative to growth
Today, value stocks appear to be relatively cheap compared to growth stocks. The Russell Indexes use Price to Book ratio (PB) as the primary valuation factor for index construction. In looking at the relationship between growth and value stocks, it is clear that the recent performance strength of growth stocks has made them much more expensive relative to value stocks
. Ten years ago the PB of the growth index was 1.8x greater than the PB of the value index (3.9 vs 2.1). Today, that relationship has become 3.1x greater (5.6 vs 1.8). That represents a 70% increase since mid-2006. Before this recent stretch, the markets had not experienced a 3x relationship since the late 1990’s. The following years experienced a value rebound relative to growth.
Of course, stocks can always become more expensive than current valuations suggest. However, markets tend to mean revert when valuations get stretched. 2016 is not a repeat of 1999, but excluding that period, it does represent the cheapest that value stocks have been relative to growth in the last 30 years.
Russell Investments believes in the value premium
The value premium represents the belief that securities that appear cheap, on average, outperform securities that are expensive. Two popular and competing explanations for this are that the value premium either compensates for risk, or that it is a result of investors’ behavioral biases. Russell Investments believes that the premium is more associated with behavioral biases
Many investors probably agree that certain stocks are cheap, but most don’t have the patience to wait for mean reversion to the “fair price” (e.g., career risk might prevent them from doing this). Those with the patience take advantage of this mean reversion, usually benefitting from the stocks moving back to their “fair price.” At Russell Investments, we believe the market may be approaching such a period where mean reversion can benefit value investors
The bottom line
With all the information available about factor investing, one element that often gets overlooked is the potential cyclicality of some of these factors. Factors can move in and out of favor for extended time periods, reducing investor confidence and patience. Russell Investments believes that the markets have been in such a period with respect to value stocks. Despite not knowing precisely when the growth vs value relationship will turn around, Russell Investments remains steadfast in its belief in the value premium. Based on the relative valuations seen in today’s market, that reward may be around the corner.