August 16, 2014

Growth vs. Value Stocks: Which Investing Style is Best?

Choosing investments is hard enough. There are endless equity indexes segmented by market cap, region, industry, in addition to fixed income and commodity funds.

Adding an additional layer of complexity, most investors are likely familiar with the Morningstar Style Box. Virtually every popular stock index seems to have a corresponding ETF to match value, growth, and blend categories.

Growth vs. Value Stocks: An Epic Battle for the AgesMany index investors seem to be particularly enamored with value investing, and specifically the small value stocks given their history (going back to at least 1927) of completely and utterly obliterating the returns of other equity classes. Old charts (link since removed) from Vanguard using Kenneth French data show that over the course of 77 years small value U.S. stocks returned and average of 15.1% per year, over 5% better than small growth and 1.6% better than small blend. Large value also outperformed large growth by 2.5% during that stretch (and 1.6% above large blend). So value investing seems like a no-brainer, right?

Kicking poor growth stocks while their down, take a look at this comparison between the Russell 1000 Growth Index (IWF) and the Russell 1000 Value Index (IWD). Over the course of the last 14 years, large value has again shown its dominance over growth. Reinvesting dividends, value has returned around 140% while growth has eked out just over 30%.

IWD vs. IWF: Comparing large cap growth to large cap value
Game over, right?
Not quite. You'll notice large growth got crushed during the aftermath of the dot-com bubble. In fact, the sell-off from 2001-2002 accounts for virtually all of the difference in the long-term performance between these two ETFs. If we instead look at the decade plus since the beginning of 2003, IWF (growth) has actually slightly outperformed IWD by about 5% (174% to 169%).

Value had a nice run-up during the housing bubble but got hit hard when that bubble popped. An investment during 2007 in large value stocks would have significantly underperformed growth.

IWD and IWF ETF comparison chart over a shorter historical period
We'll certainly have more bubbles in the future, but there's no guarantee we'll see growth valuations ever get as high as they did during the dot-com bubble. In fact, during the last decade an investment in either style would have ended up in about the same place.

Comparing small value to small growth yields a similar story. It looks brutal for small growth when the dot-com bubble is included, but over the past decade the two appear to become more closely correlated.

So which is better? In my opinion, neither. My guess is the value premium (if it even exists) will continue to disappear over time as more and more people continue writing about the value premium. When you begin to slice-and-dice your portfolio too much, you end up with all sorts of overlap between funds. In a taxable account, typically lower dividend yields might make growth funds more attractive, but yields are currently close enough between the two that it probably doesn't matter much.

John Bogle evaluated the same question with a much larger data set, spanning 63 years of returns (see about 3/4 down the page), and concluded that value only outperformed growth 11.9% to 11.8% annually during that time. The disparity in the 90s and early 2000s looks to be an anomaly in the long-run and it appears we've returned to the times of the two moving in lock-step with one another.

I'll stick with my blend ETFs.


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