While most academic literature suggests value stocks always beat growth stocks over the long run, recent market behaviour has left many investors wondering when value’s resurgence will come.

The conclusion of academia is based on the assumption that investors are compensated for the risk of owning troubled companies with low-priced shares.

While the “dumb money” chases trendy growth stocks whose price-tags overestimate their prospects, “smart beta” ETFs prefer the value factor--companies that under-promise and over-deliver.

But recent market behaviour has left many investors wondering when value’s resurgence will come. Of course, predicting the timing of market inflection points is a fool’s game. The unexpected, powerful, and ultimately short-lived rally in value stocks after the US election demonstrates this point.

Valuation, however, can be used to predict long-term future returns for the growth and value styles.

Won’t value stocks always look cheaper, by definition? Not through the lens of a forward-looking gauge of share price relative to the intrinsic value of the business. Here, we rely on the work of Morningstar’s equity analysts. Applying their valuation estimates to value and growth indexes, value wins.

Today’s US market valuations imply higher future expected returns for value stocks. That said, companies in this area don't look cheap on an absolute basis. The market’s advance from its 2009 nadir has left most stocks overpriced.

Current growth era not quite as "growthy"

To appreciate the gap between value and growth, consider the 2017 Morningstar US Market Barometer. While the overall market climbed more than 20 per cent in 2017, that figure masked a wide dispersion between the right- and left-hand sides of the Style Box. In fact, the Morningstar US Growth Index’s 29.5 per cent gain more than doubled that of the Morningstar US Value Index.

2017 Morningstar US Market Barometer

Source: Morningstar

Such growth dominance recalls the US market of roughly 20 years ago. But the performance differential during the technology, media, and telecom (TMT) bubble was larger. In 1998, the Morningstar US Growth Index returned 39.8 per cent versus the Value Index's 14.1 per cent gain. In 1999, the Morningstar US Growth Index advanced 44.5 per cent, while the US Value Index declined 1.3 per cent.
Then the bubble burst and the tables turned. In 2000, the Morningstar US Value Index gained 10 per cent, while the Growth Index lost 28.5 per cent. The Value Index suffered far less than the Growth Index in the bear market of the subsequent two years and outpaced growth during the rally of 2003-2007.

Morningstar US Growth Index vs Morningstar US Value Index

Source: Morningstar Direct

Then came the financial crisis, which hit value hard. The Morningstar US Value Index fell 58.8 per cent from 1 August, 2007 to 28 February, 2009, the timeframe utilised by Morningstar’s manager research team to capture the bear market. To be fair, the Growth Index also suffered mightily, declining 45.2 per cent over that period.

But growth has led Value off the 2009 bottom. Sectoral dynamics are part of the story. Financials, traditionally a value sector, haven’t fully recovered from the crisis; the rise of Amazon has crushed retail and real estate; and certain technology companies have booked record profits.

Macroeconomic drivers may also contribute. During periods of sluggish economic growth, the market prefers secular growth stories, for example, technology and healthcare.
Value did well in 2016 as the US election fuelled growth expectations, which lifted economically sensitive value sectors like industrials, energy, materials, and financials.

Whatever the case, growth has beaten Value in seven of the past 10 calendar years.

The fact that the highest-flying growth stocks are referred to by an acronym-- Facebook, Apple, Amazon, Netflix, and Google (FAANG)--is a cause for concern. Previous market epochs characterised by growth stock nicknames did not end well--see TMT of the 1990s and the Nifty Fifty of the 1960s.

Looking forward

If nothing else, the previous section demonstrates the cyclicality of style leadership. So, what do current valuations in the US market tell us about growth and value’s future prospects?

Morningstar equity analysts assign fair value estimates to companies using a discounted cash flow model. Economic moat, or sustainable competitive advantage, is a critical input.
A company with a moat around its business might look expensive according to multiples like price-to-earnings and price-to-book, but still be undervalued due to its ability to sustain profits. Ultimately, we believe that share prices converge with fair value.

Rolling Morningstar analyst estimates up to the index level, it appears that both growth and value are overvalued. The dispersion is significant, but not as dramatic as in the late 1990s, when TMT stock prices were completed disconnected from intrinsic value.

The Morningstar US Growth Index currently trades at a 14 per cent premium to analyst fair value, while the Value Index is seen as 7 per cent overvalued. The Core Index, which is pretty close to the overall market, is 9 per cent overvalued.

What’s an investor to do?

Of course, one could exit stocks altogether, though timing the market is notoriously difficult. Staying diversified across styles, market cap ranges, geographies, and stocks, bonds, and other asset classes is also sensible. Within equities, there’s also the option of being selective.

Choosing companies with a Morningstar moat rating is a useful place to start, and filtering further by opting for wide moat companies--tools that are available to Morningstar subscribers--provides another level of selectivity.

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Dan Lefkovitz is a content strategist for Morningstar’s Indexes group. . This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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