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Dilantha De Silva
Dilantha De Silva
Articles (185)  | Author's Website |

The Current State of the Value vs. Growth Debate

The outlook for value has improved significantly, but the rotation might take longer

December 28, 2020

As we head into a new year, it's natural for investors to evaluate the performance of their portfolios this past year to determine whether changes are required to generate better returns in the future.

A key consideration for every investor is whether they need to make any changes to the asset allocation strategy they follow. Value and growth are two of the most popular general strategy categories used by investors of every scale and size to find stocks that represent their investment objectives and risk appetite.

In this article, I will lay out my thoughts on how investors can best determine the most favorable course of action to follow in 2021 based on historical data and macroeconomic trends in the making.

The recession failed to turn the tide in favor of value

A thorough understanding of the business cycle effect is necessary to identify investment strategies that are bound to deliver attractive returns in a given time period. Historically, value stocks have performed better during the early and middle stages of the business cycle. On the other hand, growth stocks have performed well during the late stages of the cycle.

Source: Coach Investing

This observation across multiple economic cycles led many investors and analysts to believe that the Covid-induced recession and market crash earlier this year would result in a resurgence of value stocks, ending the decade-long outperformance of growth strategies. This expectation, however, has failed to materialize so far.

The global stock market has recovered since the second quarter, and U.S. markets bottomed in late-March, establishing a more forward-looking trend. In the recovery phase, so far, growth stocks have outperformed their value peers. This raises a question about the ability of value investing techniques to deliver alpha returns given how the stock market has changed in recent years.

Commenting on this disappointing performance of value, senior managing director at Wellington Management Daniel Pozen noted, "Covid-19 has been the equivalent of throwing gasoline on the fire".

The tech sector emerged as the most important industry to the recovery of global business activities this year amid lockdowns and people simply staying at home more in order to avoid getting sick or infecting their loved ones. This paved the way for high-growth tech companies to remain red hot in the market, and value stocks, therefore, continued to play second fiddle.

The below chart provides a visual illustration of how value has significantly outperformed growth before and after the market crash of 2020.

Source: Wellington Management

The second-quarter performance profile of these two strategies exhibit a significant deviation from historical norms, and this calls for an investigation of the differentiators to form an opinion of what to expect in 2021.

The stage is set for a comeback from value

The significant underperformance of value strategies since the fallout of the 2008 financial crisis has led some investors to lose faith in this investing technique that has helped the likes of Warren Buffett (Trades, Portfolio) generate alpha returns for many decades.

To pinpoint the reasons for this, a good place to start is to look at the value the market is attaching to the future earnings of a company. The bird in the hand should always be worth two in the bush, but things do not follow this pattern when it comes to stock markets. As illustrated below, close to 50% of the U.S. market value is derived from future expectations, which is at a 20-year high.

Source: Wellington Management

In other words, many growth stocks are significantly more expensive than the historical mean, and decades' worth of earnings growth have already been baked into the market price of many companies. This is not a sustainable trend, and a market sell-off that brings the valuation level to a more reasonable one can happen any time.

The outperformance of growth and value has historically been cyclical, and this is illustrated below. Understanding this characteristic is critical, as it helps rule out the possibility of value investing never making a strong comeback.

Source: Vanguard

In addition to a few renowned analysts on Wall Street, well-known academic professionals are turning bullish on value stocks. For instance, Wharton Professor of Finance Jeremy Siegel, whose opinion is highly valued by investors, told Advisor Perspectives:

"I also thought value would finally outpace growth this year. But the pandemic was obviously a dream come true for growth and tech investors. These firms bridged the gap and were critical to maintaining commerce. But we'll get a substantial reopening of the economy by the middle of next year and a complete reopening by the end of the year. Value stocks will also benefit from investors searching for yield. I believe value will outperform growth stocks in 2021."

The long-due rotation from growth to value might occur as early as 2021 according to the guru, but investors should always pay attention to the risks to this thesis as well.

The counterargument

Even though there is a lot to like about deeply undervalued business sectors and stocks at the moment, it always pays handsomely to look at both sides of the equation before jumping to any conclusions. One of the primary arguments for the continued outperformance of growth strategies is the ultra-low interest rate environment. Empirical evidence suggests growth-oriented companies thrive in such conditions because many of these companies can borrow at low rates and inject the funds into highly profitable capital investment projects. A research article published by the CFA Institute used the below factors to develop a model to evaluate whether there is any substance to these claims.

  1. Fed funds rate.
  2. Market risk premium.
  3. The required return on equity.
  4. Earnings growth rate.
  5. Terminal value.

The below excerpt from the report summarizes the findings of this exhaustive model:

"We re-ran all the above analyses using different time horizons, risk premium levels, and dividend levels and find qualitatively similar results as those in the preceding graphs. All in all, the results highlight that in a near-zero interest rate environment, investors ought to keep an eye out for companies with high terminal values and significant growth rates in their earnings/dividends. In other words, growth stocks. On the other hand, in a high interest rate environment like that of the 1980s, investors would be better off targeting the true current dividend paid by a firm. Which means they should be on the lookout for value stocks."

Even though a rotation to value is long due, nobody has a crystal ball to foresee when this would happen. Growth stocks, in the meanwhile, continue to benefit from favorable macroeconomic conditions, and it would not come as a surprise if this strategy continues to deliver stellar returns to investors in the foreseeable future.


Historical data suggests the outperformance of growth and value is cyclical, and the pendulum is bound to swing in favor of value in the future. There is, however, no conviction as to when this would happen.

Because of this reason, value investors need to remain patient and continue betting on good companies trading at cheap or fair valuation multiples. One of the best strategies, in my opinion, would be to combine the theories of both these techniques to find some middle ground. Such a framework will help filter out the most expensive growth stocks while enabling an investor to gain exposure to companies that are performing well from a financial perspective.

Disclosure: The author does not have any shares mentioned in this article.

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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I\\\'m a CFA level 3 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). I am a registered candidate for the Chartered Wealth Manager program as well. During my free time, I enjoy reading.

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