Why U.S. value stocks are poised to outperform growth

What drives the relative performance of value and growth stocks?

To better understand past results and provide estimates of future returns, we identified fundamental forces—some secular, others cyclical—that drive changes in the value-growth relationship and constructed a related fair-value model. Our model suggests that value stocks’ underperformance in recent years owes mainly to fundamental drivers, particularly low inflation rates, which boost the relative attractiveness of growth stocks’ more-distant cash flows. But investor behavior has played a role as well.

We expect value to outperform growth over the next ten years by five to seven percentage points, annualized, and perhaps by an even wider margin over the next five years.

To be clear, our outlook is for the style factors, or what might be termed “pure” value and growth portfolios. These differ from both the academic value-growth data presented in the first chart and style-specific market indexes that serve as benchmarks for many real-world investment portfolios.

An explanation of our methodology

The Fama-French data have the virtue of a long history, dating to the Great Depression. But few investors are in position to implement the academic definition of value, which includes holding the cheapest stocks while selling short the most expensive stocks.² To assess the performance of investable value and growth portfolios, we constructed market-capitalization-weighted indexes of companies in the bottom and top thirds of the Russell 1000 Index, sorted by price/book ratios and reconstituted monthly.

Why not simply examine the Russell-style indexes? Arguably, the indexes do a good job of representing active managers’ security selection. But that doesn’t make them ideal representations of the style factors themselves. Roughly 30% of Russell 1000 Index constituents appear in both the growth and value indexes, while the remaining 70% are classified exclusively as growth or value.

In our view, a stock thought to represent a style factor should, for analytical purposes at least, represent only one style. In our model, a company can be deemed only value or growth in any given month, though its classification may vary from month to month.

Why value stocks are poised to top growth stocks

It’s well-known that asset prices can stray meaningfully from perceived fair values for extended periods. So why should investors expect value to outpace growth in the years ahead? For one, we believe the growth trade is overdone.

Our research found that deviations from fair value and future relative returns share an inverse and statistically significant relationship over five- and ten-year periods. The relationship is an affirmation that, ultimately, valuations matter—the price we pay influences our return. That’s intuitive, right? So, too, is the imperfection of our model: While it reveals a relationship between fair-value deviations and future results, its predictions for relative performance are imprecise. That’s consistent with investment risk enabling but not guaranteeing potential returns. Put another way, if valuations perfectly presaged performance, there’d be no risk. Fortunately, that’s not how markets work.