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When Value No Longer is Value
Small Cap Tilt Due to Swing to Growth
By Erik Ogard, Portfolio Manager
Russell Investment Group
Global Leaders in Multi-Manager Investing
March 15, 2005
The following article has been issued by our parent Frank Russell Company in Tacoma, Washington and is referring specifically to the US market unless otherwise noted.
Have value stocks formed a bubble that is about to burst? Increasingly, many money managers believe they have.
Mounting evidence, added together, leads to one conclusion: Value has grown too far too fast and an inevitable retreat is in sight. Money managers believe it is particularly true of small-cap value stocks.
Of course, they could be wrong.
Historical patterns do not always repeat themselves. This pattern could be the start of a new world in which value will be king for an extended period. Indeed, growth may have gone out of fashion, never to return to the spotlight.
But then we heard a lot about "a new economic paradigm" in the late '90s in which growth stocks were king. Those who believed in it — and invested accordingly — were left with little more than disillusionment a few years later.
Too Much Growth for Value?
The major aspect concerning money managers is that value has beaten growth for simply too long. Accepting that the historical tendency still holds for growth and value balance one another over time, value's size in the past few years has become too big. It is growth's turn to shine.
Going back to 1979, value stocks have maintained a slight edge on growth. But the margin generally has been much smaller than now. Seldom before has value won by as much as it is winning now and for as long as it has won.
As the Russell 2000® Growth and Russell 2000® Value indexes indicate, over the past 11 years, value has beaten growth in seven years. In the past five years, growth led only in 2003 with a 48.54% return compared to 46.03 for the Russell 2000 Value.
Money managers cite many factors as evidence of a potential "value bubble."
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- On an annualized basis, by mid-February the Russell 2000 Value had grown 16% over the previous five years and the Russell 2000 Growth had shown a negative return of 7%. That's a massive 23% annual difference.
Even over 10 years value has outperformed growth by an annualized 9% (value rose 15% and growth 6%.) Historically, that difference, too, is large.
- The time over which growth has beaten value has recently been consistently shorter than the historical norm.
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When growth has beaten value historically it has tended to do so over periods of 18 to 24 months. But growth has not beaten value for that length of time for 10 years. In addition to value winning by a large magnitude, therefore, we have experienced an unprecedented time period in which value has beaten growth.
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- Stocks in the Russell 2000 Value Index are, on average, near their most expensive since the index began.
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Measured using the price-to-book ratio, for example, value stocks are at 1.785; the historical maximum is 1.793. The stocks have become more expensive as the index has moved higher.
The Large-Cap Connection
Another event, however, needs to occur, if the historical precedent holds. In order for small-cap value stocks to fade, large-cap growth stocks need to prosper. Such an event would be in line with the economic cycles that usually have occurred in the markets.
Against this background, the prospects for growth stocks look good. Companies are sitting on mountains of cash. How they choose to use it may have a strong impact on the markets.
They could apply the cash, for example, to dividend payouts. They could repurchase stock. They could acquire other companies. Or they could invest the money back into their company.
This scenario is, in many ways, the antithesis of 1999. In those days, growth companies were acquiring other companies with stock that had been bid up to unrealistic levels that bore no relationship to the real value of the company. The result was a house of cards that was ready to collapse.
Now companies are able to buy others at lower prices because so many growth companies are under-priced. Moreover, they are able to use cash, not stock.
In addition, the valuations of growth companies are compelling. Their prospects look good.
Money managers, therefore, think we are about to reach a corner where the buying power will turn from value to growth stocks. But we are not sure how far we are away from turning that corner. Nor do we know how big the turnaround will be.
In the meantime, investors should keep to their target goals and not be tempted to buy more value stocks simply because they have done so well recently.
Rebalancing to target asset allocations remains appropriate for most investors. It may help to avoid a hard landing when a bubble bursts.
This is a publication of Russell Investments Canada Limited. Nothing in this publication is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The contents in this publication are intended for general information purposes only and should not be acted upon without obtaining specific legal, tax, and investment advice from an investment professional concerning your own situation and any specific investment questions you may have.
The information, including any opinion, is based upon various sources we believe to be reliable but its accuracy cannot be guaranteed. It is for information only, is subject to change at any time, and does not constitute an offer or solicitation to buy or sell securities referred to.
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