Is it Time for the Tortoise to Win?

Twenty years ago, Dr. William Sharpe introduced the investment world to the idea of categorizing investment strategies into styles – growth vs. value, large companies vs. small companies, etc. His theory was straightforward – if you group securities with similar risk-return characteristics (or “styles”) into a finite number of categories, you can build portfolios that have a better risk-return profile. As human beings, we like to group things into boxes, so the introduction of style boxes and their inherent simplicity resonated with the investment community. Typically, we think in two dimensions – growth versus value investing and large (i.e., large cap) versus small companies (i.e., small cap). For the purposes of this article, we’re going to focus on growth versus value investing.

In the fabled race of the hare versus the tortoise, the speedy rabbit loses to the crafty turtle. Some investors believe they should put their bets on slow and steady value investing (the turtle) to win every race. For the past seven consecutive years, this has been a winning bet but, at some point, won’t the hare (growth investing) wise up and combine his speed with some learned cunning to win? Historically, the hare does win a few races, unlike the end in the children’s fable.

Growth investing involves investing in stocks of companies that exhibit signs of above-average growth, as compared to other industry players or the overall market, even if the share price appears expensive based on fundamental factors such as price-to-earnings ratio or price-to-book value. Growth investors will use any number of metrics such as accelerated earnings growth, marked revenue expansion, and increasing market share. Recent examples of growth stocks include Google (93.4% average annual revenue growth over the past 3 years) and Harrah’s Entertainment (34.81% average annual earnings growth over the past 3 years).

Value investing involves investing in stocks of companies that appear to be undervalued according to certain fundamental factors such as high dividend yield, low price-to-earnings ratio, or low price to book value, among others. Value investors desire to buy stocks that are trading below their intrinsic value, typically defined as the present value of future expected cash flows. Recent examples of value stocks include Verizon (current dividend yield is 4.35% versus the market yield of 1.82%) and ExxonMobil (2007 P/E is 11.83; compared to the Russell 1000 P/E of 17.53).

What if we were to view the competition between the hare (growth) and the tortoise (value) as a multiple event athletic competition? The winner-loser dynamic could change if you assume they compete on strength in a tug of war. Historically, growth and value have seesawed in terms of performance. Sometimes growth outperforms value and other times, value outperforms growth. The difference in returns between these two styles can be significant at times. Over the past thirty years, growth has outperformed value 19 times and value has outperformed growth 19 times (as measured by consecutive periods of out performance, with a one month minimum) – a tie score.

Periods of out-performance for both styles can last quite a long time. Growth and value cycles (i.e. one outperforming the other) have on average, lasted roughly 3.5 years. However, the current value cycle has lasted significantly longer than the historical average, and is interestingly enough the same duration as the most recent growth cycle (1994-2000). This ultimately resulted in the devastating collapse of the growth-technology bubble which led to the second worst bear market on record. Could value be ready for a reversal of fortune?

The most recent period of value out-performance has been distinguished not only by its duration, but also by its sheer magnitude versus the historical average. Value has experienced a cumulative return more than 98% greater than growth since the fourth quarter of 2000. To put this into perspective, $100,000 invested in the Russell 1000 Value index in the fourth quarter of 2000 would have grown to $169,190, $98,700 more than the same amount invested in the Russell 1000 Growth Index.

Return To Mean Likely

While the old adage that past performance doesn’t guarantee future returns does apply, history offers us lessons to help minimize the risk of repeating past mistakes. Any time the performance of two asset classes experiences their greatest historical divergence (e.g., such as growth over value in the late ‘90s and the current situation of value over growth), investors need to be aware that the trend may shift swiftly, severely, and without advance notice. As we all know, trends do reverse and the effects can be devastating.

In the event that your portfolio has been riding on the back of the turtle’s shell (i.e. you’ve had an over-weighting to value) expecting to win every year, you may already be re-evaluating your asset allocation (always within the context of your goals and objectives). Perhaps you are convinced (for the umpteenth consecutive year) that growth is due for a comeback, and value for a mean reversion. After all, even a stopped clock is right twice a day. Perhaps it’s just time to quit the guessing game and adopt a core approach, which has exposure both to growth and value, as well as other non-style-specific mandates. This approach can help better manage volatility and take the guessing out of which style will outperform the other in a given year.

In taking such a core approach, it is prudent to have managers in your portfolio with different sources of alpha, or insights into the markets that are not strictly wedded to the growth or value styles. By complementing the existence of style-based managers with others whose investment processes focus on factors other than growth or value, your portfolio may provide greater opportunity, and lower volatility. For example, there are managers who choose exposure to sectors and stocks based on whether their prices are moving up at an increasing rate (momentum managers). As such, those managers will either look like value or growth managers depending on which style is more in favor as indicated by their price momentum. In many cases these managers tend to be quantitative, and don’t care about being labeled as growth or value managers. Their investment processes are designed to capture inefficiencies in order to out-perform the overall market, meaning a bias toward a particular style is simply an outcome of their process, not the objective.

Few investors, if any, have the ability to consistently and accurately determine which styles will be in and out of favor at a given time. Therefore, in order to avoid getting whipsawed when a particular style suddenly falls out of favor, it may be prudent to incorporate multiple types of strategies (not just styles) into your portfolio. In the final analysis, diversification is key; not just diversification of asset classes, but also diversification of manager insights into markets. So, when you think about betting on animal races, consider broadening your opportunity set, placing bets across the animal kingdom – rabbits, turtles, squirrels, chipmunks; the list goes on. There’s more than one way to win the race.