Are Investors Electing Value Over Growth?

Every so often the market creates “widow maker” trades. Those are trades that seem logical, yet fail to work – often for years on end.  One of the current widow makers is hurting those who prefer value stocks over growth equities.

The classic widow maker trade was shorting Japanese government bonds (JGB). That was a classic one-tailed trade. With the bonds yielding nearly zero, it appeared obvious that yields would not go below zero (this was before Europe went to negative rates) and had plenty of room to rise. But the yields never rose appreciably. The Bank of Japan proved to be a relentless buyer, meaning that traders who shorted JGBs rarely saw those bets pay off.

For the past few years, and especially during the past few months, growth stocks have dramatically outperformed value stocks. The distinction between growth and value is somewhat arbitrary, of course. To oversimplify, growth stocks have the potential for, and often demonstrate, substantial earnings growth, while value stocks show consistent, but slower earnings rises. Value stocks tend to pay higher dividends, while growth stocks usually prefer to invest their earnings into their rapidly growing businesses. Tech stocks are almost always considered growth stocks, while basic industries are almost always put into the value basket.

To demonstrate the arbitrariness of the distinction, consider these two examples. Company A has a 5 year earnings growth rate of 8.9% and a dividend yield of 0.72% (according to Bloomberg data). Company B shows 10.88% earnings growth over the same period and a dividend yield of 2%. Which is the growth stock and which is the value stock? Would it surprise you that Company A is Apple (AAPL), one of the market’s classic growth stocks, and Company B is Clorox (CLX), a value stock bellwether?

As traders learned in the JGB example, it is tough to overcome relentless money flows. Growth stocks are certainly the beneficiaries of money flows related both to their mind share among performance chasing investors, but they are also the beneficiary of passive money flows. As investors put money into S&P 500 Index funds, about 25% goes into highly valued growth stocks. The relatively higher valuations of growth stocks lead to higher index weightings, which lead to greater percentages of passive money flows, and so on. They are benefitting from positive feedback loop that may be unintended by those who index their investments.

Over the past few sessions we have seen a notable outperformance by value stocks as we head into Election Day. Investors are putting their faith into a Democratic victory that will bring about a significant fiscal stimulus package. (Never mind, of course, that both the election results – particularly for the Senate – and the potential timing of that stimulus are highly uncertain.) The market now anticipates that such legislation will benefit the economy as a whole, benefitting the stocks that are most leveraged to economic cycles.

Interestingly, in a near-zero rate environment, few investors seem to care that there are many value stocks with tangible dividend yields that are supported by steady earnings. Dividends remain the un-sexy part of an investing climate where most are seduced by the prospect of capital gains.

The past few days have shown some signs that the value vs. growth widow maker trade is abating. Unfortunately, a few days do not make a lasting trend. While I personally believe that value stocks are a sound long-term investment, I do not see evidence that investors have fully recognized their charms.