Over the last decade, value stocks have underperformed when compared to growth stocks. However, several signs point to this long-term slump coming to an end.
Value investing has seen better days. The alluring returns of growth stocks, particularly concentrated in the tech sector, are far more enticing to institutional investors and retail investors alike. There’s no shortage of investors ready to call the time of death for value investing — but 2021 could be the year that proves them all wrong.
In fact, we might be looking at an extended period of time in which value investing will make a big return. And this isn’t just idle speculation: Well-established, respected names in the financial space share this sentiment, including Vanguard.
But we don’t have to take their word for it. While the numbers clearly suggest that value stocks will make a strong comeback, a large part of that process will be driven by common-sense investing in the months to come.
Let’s jump into precisely what that means.
Why Value Stocks Have Underperformed
First, let’s deal with the performance of value stocks in recent years. Looking at data from the last decade, it is apparent that growth stocks have outperformed value stocks by quite a large margin. And although that fact has caused many to declare that growth stocks are intrinsically superior, this is a narrow and shortsighted approach.
Let’s take a look at the data. Vanguard’s Russell 1000 growth index (VRGWX) has seen returns of 16.36% when looking at a 10-year period, while the Russell 1000 value index (VRVIX) has netted investors returns of 10.32% in the same timeframe.
Although returns of 10.32% are below the 13.6% current 10-year average of the S&P 500, it is clear that value stocks are far from a thing of the past. In fact, this level of performance is encouraging, considering that market conditions have been very unfavorable toward value stocks in the past decade.
What market conditions, you may ask? It’s simple — portfolios that focus on value stocks frequently overweigh industries that haven’t fared so well in the past 10 years, such as energy, utilities and the financial sector. On top of that, it has been demonstrated that low interest rates have a negative effect on value stocks while bringing a positive effect to growth stocks at the same time.
Growth and Value Cycles
We’ve established that growth stocks have outperformed value stocks in the last decade, but don’t let that fool you. Historically, value stocks have netted investors far greater returns over the long run.
Does this mean that value stocks are always the right call? Well, no. An individual investor’s own investment timeframe is much more important than long-reaching historical data. Up to this point, investing mostly in growth stocks was the better option, but only because we’ve been in a growth cycle.
Much like the market has bullish and bearish cycles, it also has growth and value cycles. As we’ve discussed, the last 10 years have been part of an (admittedly long) growth cycle, driven primarily by tech stocks. However, the conditions that lead to this aren’t set in stone.
In fact, the current growth cycle might be at an end. Although tech stocks may continue to rise, it is uncertain if they can retain their current rate of growth. The largest cause of their meteoric rise, by far, is the monopolization of services.
With Google, Amazon, Netflix and others like them having already carved up impenetrable economic moats, whether or not they will see a continued rise in share price is an entirely valid question.
The possibility of higher interest rates and inflation also brings another element of uncertainty to the future of tech stocks.
Stimulus Payments, Reopening the Economy and Value Stocks
The single most important event that will accelerate the return of value stocks is the stimulus in the U.S. and the eventual reopening of the economy after the COVID-19 pandemic.
Although stimulus payments likely won’t cause as much inflation as the most pessimistic among us think, inflation will occur, thereby curbing the returns of growth stocks and increasing the returns of value stocks.
As the economy reopens, sectors that have been hit hard by the pandemic will likely see a rapid recovery. Reopening the economy will lead to a much larger cash flow for currently undervalued businesses, which will allow them to invest in further growth. This, in turn, will lead to a renewal in investor confidence, culminating in a domino effect of rising stock prices.
If, in fact, the Biden administration passes the sweeping infrastructure bill that it has promised, you should also keep in mind that infrastructure stocks could be poised to see a large increase in price. Many see the industry as undervalued as of late, which can add to the appeal of Biden’s agenda.
What to Keep in Mind Amid Rising Tides
The old adage of rising tides lifting all boats hasn’t fared all too well when it comes to the economy. The expected recovery of the U.S. economy will certainly have a very positive effect on a lot of businesses — perhaps most businesses, even. However, this doesn’t mean that value investing will suddenly become a foolproof silver bullet.
Growth stocks certainly have a place in portfolios, and any warning with the tech sector doesn’t mean that growth should be avoided. In fact, the tech industry is a prime candidate for value investing. However, you should keep an eye out and avoid tech industry value traps — innovative companies that attract a lot of venture capital without actually bringing a product to market.
Look for companies that have intrinsic value, and that you truly believe in. While that may seem like generic advice, something tells me that this year, it could become a lot more profitable than it has shown to be in years past.
Founder, Lakeview Capital
Tim Fries is co-founder of Protective Technologies Capital, an investment firm focused on helping owners of industrial technology businesses manage succession planning and ownership transitions. He is also co-founder of the financial education site The Tokenist. Previously, Tim was a member of the Global Industrial Solutions investment team at Baird Capital, a Chicago-based lower-middle market private equity firm.