Recently, growth stocks have significantly outpaced value, prompting investors to question if it is time to reallocate to value. In an environment where strong fundamentals support growth and cheap valuations favor value, we believe investors should be well diversified. Our asset allocation portfolios are close to neutral, with a slight overweight to U.S. growth stocks.
Over the last three years, the Russell 1000 Growth Index has outperformed the Russell 1000 Value Index by over 55% on a cumulative return basis. If you count for compounding, that’s over 15% a year outperformance for growth stocks over value stocks. So, what should investors do? Should they rotate out of growth stocks and buy value stocks, or should they stick with the winning assets class? I would argue that investors should, in this environment, be well diversified between value and growth.
In our asset allocation portfolios, we maintain a long-term strategic allocation to both growth and value stocks, and from a tactical perspective, we are very close to neutral between the two. We have a slight overweight U.S. growth stocks at the moment. Let’s look at both sides of the coin.
First, the outperformance of growth stocks can, in great part, be explained by superior fundamentals. If you look at a chart of cumulative forward earnings over time, you’ll see that the gap in favor of growth stocks, especially recently during the COVID crisis, explains a lot of that massive return differential in their favor. In a low growth, low interest rates, low inflation environment, growth stocks tend to perform better, and they have a sector advantage being more exposed to technology in particular. So, from a secular perspective, there is an argument to be made to favor growth stocks because a lot of those companies are the disruptors rather than the disrupted.
But value stocks do look cheap in the current environment. It’s difficult to estimate forward earnings, but nonetheless, when valuations get extended like that, it’s like a coiled spring. It doesn’t take a lot of good news to get a rally. Also, we have done a study going back 90 years, where we’ve looked at 17 different sell-offs similar to the one we just had in terms of magnitude, and we found that generally speaking when the market recovers, value stocks tend to do better on average. In this market recovery phase, we haven’t seen value stocks outperform yet because of the nature of the shock.
So, those are the two sides of the coin. Fundamentals seem to favor growth, valuations favor value stocks. In that context, it makes sense for investors to stay close to neutral, well diversified between both value and growth stocks.