Looking Forward, Value is Easier to Own

Even though value stocks have outperformed growth stocks this year by a solid margin, growth stocks are still running laps around value stocks when you look at the last five or ten years.

The S&P 500 Value index, for example, was up 10.8 percent for the five years ending on Friday, and 12.0 percent for the last 10-years. While those returns are attractive in absolute terms, they are pretty paltry compared to growth. The S&P 500 Growth index was up 19.6 percent in the last five years, and 16.8 percent in the last ten years.

And that’s after the recent run-up in value. So far this year, the Value index is down -2.0 percent and the Growth index is down -10.8 percent. That closes the gap some, but there’s obviously a lot more to go.

Over the weekend, I took a look at some of the valuation metrics for the growth, value indexes and compared them to the S&P 500 as a whole. I was a little surprised.

Let’s start with the good, old-fashioned price-to-earnings (p/e) ratio, as calculated by Morningstar on some exchange-traded funds that track the aforementioned indexes.

As a reference point, the S&P 500 has a p/e ratio of 20.4, which simply means that if all of the stocks in the index had earnings of $100, the value of those stocks is $2,040. We can also divide those $100 of earnings by the market value of the stocks of $2,040 and say that the earnings yield is 4.9 percent.

Now, earnings are an imperfect measure for a lot of reasons, most notably that management manipulates them, but let’s just use that as a starting point.

If we look at the same ratio for value stocks, the p/e ratio is 16.7, which has an earnings yield of 6.0 percent. We can also say that value stocks trade at an 18 percent discount to the market based on this metric.

If we look at growth stocks and do the same thing, the p/e ratio is 26.1, which is equal to an earnings yield of 3.8 percent. And, we can say that the growth index trades at a 28 percent premium to the market.

And, we can take it a step further and say that growth stocks trade at a 56 percent premium to value stocks based on these metrics (26.1/16.7).

Actually, we can take it several steps further and look at other metrics beyond the p/e ratio and look at the price compared to other fundamental metrics like sales, cash flows, and book value of the company.

If we do the same exercise as above with the average of these four metrics (p/e plus the ones I just referenced), we find that value stocks trade at a 25 percent discount to the market and growth stocks at a 53 percent premium. Said another way, growth stocks are trading at twice the valuation of value stocks (1.50/0.75).

Sounds compelling, right? I think so, but I also want to roll out some of the important caveats.

  1. Just because value stocks are cheaper, doesn’t mean it will do better – just look at the last five or ten years.
  2. Just because value stocks are cheaper, doesn’t mean that they won’t fall in a broad market selloff – they will.
  3. By definition, value stocks are always cheaper than growth stocks – they shouldn’t be called value and growth, they should be called cheap stocks and expensive stocks. It’s more relevant to look at the magnitude of the difference, which is unusually high right now.
  4. Value stocks are cheap for a reason – they don’t grow as fast, they aren’t as profitable, and they aren’t in as strong a financial position.

Those aren’t legal disclaimers, they’re the things that you have to know about value. And, despite all of that, value stocks have historically outperformed growth. Not always, as the last ten years clearly demonstrate (and there were other ten-year periods too).

The point that I’m trying to make is that if you’re bothered by the overall market valuation, take heart that value stocks look pretty unusual cheap versus the market and growth stocks (take heart: Valentine’s Day pun intended).

My view is that value stocks were hard to hold for the last five years (those five years were so good that they unduly influence the ten-year numbers), but that’s looking backward. If you look forward at valuations, they are a lot easier to own in my opinion.