This is why the smart money is betting on value stocks to outperform growth
You should be skeptical of the growth story that catches the attention of stock market investors from time to time. Indeed, the companies that Wall Street predicts will grow the fastest in the future rarely live up to investors’ lofty expectations.
The latest episode of this growth stock fever happened this week. Investors jumped on the growth bandwagon on Wednesday after Federal Reserve Chairman Jerome Powell signaled that the Fed would slow the pace of future rate hikes. SPDR S&P 500 Growth ETF SPYG,
during today’s session, the SPDR S&P 500 Value ETF gained 4.3%, far outpacing SPYV’s 1.9% return,
Meanwhile, Invesco QQQ Trust QQQ,
It gained more, 4.6%, which is heavily weighted to tech stocks, which are mainly growth stocks on steroids.
As it turns out, the investor’s reaction makes some sense because the present value of future years’ earnings increases as interest rates fall. Because the gains of growth stocks go into future years more than the gains of value stocks, growth stocks should benefit disproportionately when rates fall.
Or so goes the growth stock logic. The Achilles heel of this rationale is the assumption that growth stocks’ earnings will grow faster than value stocks. Most of the time it is not.
This is difficult for investors to accept because growth stocks are often stocks with well-above-average earnings growth in prior years. However, a company’s past earnings growth rate does not mean that it will continue to grow at that rate in the future.
According to several major research projects over the past two decades, we should expect profits to fail to keep pace with this rate. One of the first published 25 years ago Financial journal, led by Louis KC Chan (Head of Finance at the University of Illinois at Urbana-Champaign) and Jason Karceski and Josef Lakonishok (of LSV Asset Management). After analyzing US stock data from 1951 to 1997, they found that “there is no persistence in long-term earnings growth beyond chance.”
Two researchers from financial management firm Verdad recently updated this Financial magazine research to focus on 25 years since publication. They are Brian Chingono, Verdad’s director of quantitative research, and Greg Obenschein, a partner and director of credit at the firm. They came to the same conclusion as the previous study: “[W]We find little or no evidence that earnings growth is beyond chance over the long term,” they concluded.
The table below summarizes what Verdad researchers found for companies with the top 25% in earnings growth in a given year. They looked at how many of them, on average, were in the top half for EBITDA growth in each of the next five years. That’s a pretty low bar to jump, but many, many years have failed to break it.
| The % of top quartile of companies for earnings growth in a given year is above the median for EBITDA growth… | Expectation based on chance/pure chance | Difference from pure chance (in percent) | |
|
End of next year 1 |
48.8% |
50.0% |
-1.2 |
|
End of next year 2 |
23.0% |
25.0% |
-2.0 |
|
End of next year 3 |
12.3% |
12.5% |
-0.2 |
|
End of next year 4 |
6.8% |
6.3% |
+0.5 |
|
End of next year 5 |
4.0% |
3.1% |
+0.9 |
Note that these results do not mean that the global stock market should not rise again this week in response to the expected pivot from the Fed. Instead, these studies discuss the relative performance of value and growth stocks. Growth should not outpace value because interest rates may fall, just as interest rates may rise because value should not outpace growth.
So keep that in mind the next time the Fed rolls around. If the market reacts with a strong bias against growth or value, a bold contrarian bet would be to predict that the reaction will soon correct itself. Therefore, counterparties are currently betting on value rather than growth.
Mark Hulbert is a regular GameSpot contributor. It tracks investment newsletters that pay a fixed fee for its Hulbert Ratings audit. You can apply to him mark@hulbertratings.com
Also read: The “pivot” for the Fed to cut interest rates will be bullish for stocks. But timing is everything.
More: Strategist Ed Yardeni said the key word for investors to decipher the Fed’s next move is “moderation.”
