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Equity Perspectives

Weighing in on this topic are Lord Abbett Partners Walter Prahl, Director of Quantitative Research, and Tom O'Halloran, Director of Growth Investing. 

Memories of the turmoil of 2008–09, combined with continuing sluggishness in the economy, have kept many investors on the sidelines, despite the subsequent stock market rebound. Some, however, have ventured in, lured by attractive dividend yields. In light of the economic turmoil, the appeal of dividends is clear: they may provide not only a reassuring cash flow but also a cushion in the event of another market downturn. But while capturing dividend yield may be an appropriate strategy for many, investors concerned about economic weakness should not discount growth stocks. In fact, for those whose personal economic circumstances are closely tied to the business cycle, growth may be a more appealing choice.

The Conventional Wisdom
The idea that growth stocks could in any sense be cautious or conservative flies in the face of popular opinion. Growth investors are typically viewed as optimistic and bullish, while value investors may appear to see the glass as always half empty.

But in reality, the assumptions behind growth investing can be viewed as more pessimistic, according to Richard Bernstein, style-investing expert and former chief investment strategist at Merrill Lynch. Growth's "underlying theme," Bernstein writes, "is that the economy will be so poor and the profits cycle so weak that investors [must] search out those few companies that might actually be able to grow in that environment. Value investing is actually the much more optimistic of the two strategies because its underlying theme is that everything is going to grow, so shop around for growth."1

Growth and value managers also may be misperceived as well, according to Bernstein. "Some portray value investors as the insightful ones, while portraying growth investors as patsies... Value managers, they imply, are insightful bargain hunters, while growth managers simply play the greater fool's game."2

In reality, Bernstein says, opportunities to exercise insight abound for both types of managers. Since value investors tend to buy when a stock is out of favor, the danger for them lies in buying too early. For a growth manager, on the other hand, the danger lies in holding a stock too long.

Style Investing
Investing based on "styles"—small caps versus large caps, for example, and value versus growth—began to take off in the 1970s and 1980s. Prior to this, investors viewed the stock market as monolithic. That is, the prices of all stocks could be predicted on the basis of their volatility relative to the market as a whole. Stocks with twice the volatility of the overall market could be expected to produce roughly twice the return.

But researchers began to notice that certain segments of the market, small caps, for example, performed in a way that their model, the capital asset pricing model (CAPM), failed to capture. Likewise, growth stocks and value stocks performed in ways the model did not fully predict. Later researchers improved on the CAPM by adding factors to capture the capitalization and growth/value dimensions of a stock's performance. This ultimately led to the nine-cell Morningstar style box that classifies mutual funds as small, mid, or large cap, and as growth, value, or blend.

While academics and investment practitioners debated for years whether the growth style outperforms the value style, this dispute has, for the most part, been settled. Generally, broad agreement exists that although growth can outperform value for extended periods, in the long run, value has come out ahead.

Of course, no one can guarantee that this pattern will continue in the future, but the research is "quite uniform and consistent that value stocks tend to outperform across a full business cycle," said Walter Prahl, Lord Abbett Partner & Director of Quantitative Research. That is, although value tends to lag during an economic downturn, it tends to more than catch up when the economy rebounds. This "value premium" has been verified again and again (see Chart 1), in both domestic and foreign markets, said Prahl. "It is one of the most durable findings in empirical finance."


 

Chart 1. Value Has Outperformed Growth Over the Long Run

Source: Bloomberg. Data through September 30, 2013.
Past performance is not a reliable indicator or guarantee of future results.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. An investor will not experience similar results.
Historically speaking, growth and value investments tend to react differently during the economic cycle. Since value stocks are often cyclical in nature, they may benefit from the increased spending that usually occurs during an economic expansion. Growth stocks may also perform well during an expansion, but they may also be out of favor during market downturns, when investors pay more attention to price ratios.
While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are under valued, and they may not appreciate as anticipated.
* The chart sets the value of each index as of December 1989 at 100.0 and shows how much each index has performed since that time. As of September 30, 2013, The Russell 3000 Value Index was more than nine times higher than it was in December 1989 and the Russell 3000 Growth Index was more than six times higher than it was in December 1989.


What Is Value? What Is Growth?
While growth and value managers might approach their crafts quite differently, the difference between a value stock and a growth stock is not always clear. On a spectrum—with pure growth companies at one end and pure value companies at the other—the differences between those at either end can be stark. Companies in the middle, however, may have characteristics of both styles. Recognizing this, Russell Investments groups the companies in its equity indexes roughly into thirds, consisting of pure value, pure growth, and blend.

Among the largest holdings of these indexes, the difference in growth and value may not be obvious. The top holding of the Russell 3000 Growth Index,3 for example, is Apple Inc., while in the Russell 3000 Value Index,4 ExxonMobil Corp. tops the list. Technology companies are more common in the growth index, however, and financial companies predominate in the value index. (See Table 1.)


 

Table 1. Differences between Growth and Value Companies May Not Be Obvious

Source: Russell Investments. Data as of September 30, 2013.
This table is for illustrative purposes only, and the securities mentioned may or may not be held by any Lord Abbett Fund.


Of the two styles, value is easier to define. Value stocks are those that have low prices relative to their other attributes; they tend to have high dividend yields, as well as low prices versus their book values, their cash flows, and their sales.

Growth, on the other hand, is more ambiguous. In simple terms, growth companies are those that have achieved above-average earnings and are expected to do so in the future. In many cases, this growth is expected to occur regardless of the economic environment. Often these companies have developed a game-changing technology that makes their growth less sensitive to economic cycles. And because of this, the stocks of growth companies tend to sport richer valuations, as measured by price-to-earnings (P/E), price-to-book (P/B), and dividend yield, for example. (See Table 2.)


 

Table 2. Growth Stocks Tend to Grow Faster, but Cost More

Source: Russell Investments. Data as of September 30, 2013.
Past performance is not a reliable indicator or guarantee of future results.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. An investor will not experience similar results.
While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated.


Value companies also frequently have fewer resources to get them through rough patches, and this may affect their appeal. "Value stocks, almost by definition, are stocks that are closer to a state of financial distress than other stocks, and stocks that are close to financial distress are going to worry investors during a slowdown," said Prahl. "Many investors will want to sell those stocks rather than sticking around to find out if they survive the test that a recession brings."

In contrast, growth companies typically have a larger buffer against financial distress. "Think of all the growth stocks around right now that are chock-a-block with cash on their balance sheet. These companies are more likely to survive general economic distress," said Prahl.

The financial strength of growth stocks frequently stems in part from robust earnings, which derive from the strong competitive position that these companies often enjoy. Tom O'Halloran, Lord Abbett Partner & Director of Multi and Small Cap Growth, points out that this strength is one of the appeals of growth investing. "One of the premises of growth investing is that higher-quality companies are more likely to deliver in line with, or above, expectations than are average or mediocre companies."

Value companies, on the other hand, can sometimes experience extended periods of disappointing earnings, particularly during an economic soft patch. Indeed, value companies tend to be more pro-cyclical, or correlated with the real economy. The economic performance of value companies tends to suffer more than that of growth companies during a recession.

"Research has demonstrated," according to Russell Investments, "that the fundamentals of value companies—for example, earnings and dividend growth—worsen far more than those of growth companies during recessionary periods."5 Typically, value companies are found in sectors normally hit harder by recessions. Value indexes often include a large number of companies in financial services and energy, for example. Likewise, being pro-cyclical, value stocks tend to outperform when the economy recovers.

During the short recession that ran from January 1980 through July 1980, for example, value underperformed growth. Further, value tended to lag growth during the longer recession that ran from mid-1981 almost through the end of 1982, though performance was uneven. But as the economy roared back, value beat growth fairly decisively. (See Chart 2.)


 

Chart 2. Growth Can Outperform Value When the Economy Is Weak
Four-quarter moving average of the difference between return of Russell 3000® Growth Index and return of Russell 3000® Index Value, First quarter 1980–Third quarter 2013

Source: Bloomberg and Bureau of Economic Analysis. Data through September 30, 2013.
Past performance is not a reliable indicator or guarantee of future results.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. An investor will not experience similar results.
Historically speaking, growth and value investments tend to react differently during the economic cycle. Since value stocks are often cyclical in nature, they may benefit from the increased spending that usually occurs during an economic expansion. Growth stocks may also perform well during an expansion, but they may also be out of favor during market downturns, when investors pay more attention to price ratios.
While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are under valued, and they may not appreciate as anticipated.
* Real GDP growth is the growth in GDP adjusted for inflation.


Likewise in the early 1990s, growth and value alternated with the recession and subsequent recovery. And although the outperformance was not consistent, growth beat value in the recession that ran from December 2007 through June 2009.

The tech bubble and its aftermath represent a stark exception, however. Growth outperformed during the tech run-up of the late 1990s, but value benefited after the collapse, even though the economy sputtered. During the downturn that began in March 2001 and ran through November 2001, growth substantially underperformed value. This may have occurred because of the tech bubble of the late 1990s. During that period, growth stocks became so overvalued that outperformance became difficult, especially as the bubble collapsed.6

This vividly illustrates another distinction between value and growth. As O'Halloran notes, risk is multidimensional. While value companies may be in a more precarious position financially, "company risk is just one piece of the puzzle," he said. "As growth investors, we take on lower company risk than value investors do. But we acknowledge that we usually take on greater valuation risk. To just focus on company risk in comparing value versus growth is an incomplete analysis, in my view. Normally, the value investor takes on more company risk; the growth investor takes on more valuation risk."

All told, growth has tended to beat value during most economic downturns of the last three decades. But the outperformance of value over the long term demonstrates that investors who have held value stocks during these downturns ultimately have been compensated for taking on this risk.

"If there were no potential return advantage in holding value stocks across the entire business cycle, then there would be no reason to hold them," Prahl explained. "You'd be exposed to the risk of holding an asset that underperforms precisely when you might need to sell it, and there would be no advantage in doing that."

Value, Growth, and the Business Cycle
Higher returns are normally associated with higher risk, but in the case of value stocks, the reason for the long-term outperformance remains subject to debate. In fact, it's not clear at all that value stocks are riskier in an absolute sense. Their returns are more positively correlated with the business cycle than those of growth stocks, but this does not by itself mean that they are riskier across the full business cycle.

The historical tendency of value stocks to be pro-cyclical, however, carries investment implications. It means that they may be more suitable for some investors than others. For those who have difficulty tolerating performance that tends to swing in tandem with the ups and downs of the economy, value stocks may be less appealing.

These swings in performance may be especially difficult to tolerate for investors who anticipate needing to liquidate some holdings during an economic downturn. Those who work in cyclical industries, for example, and expect layoffs, or who own a business and can foresee a loss of revenue, may be more averse to this kind of volatility. In this situation, those holding only value stocks could find their portfolio underperforming just when they need it most. "If you're an investor like that," said Prahl, "there's a good argument for considering growth stocks."

This correlation of value stocks with the real economy may, in fact, explain why they have outperformed historically. For investors who don't anticipate having to raise cash, there arguably is no greater risk at all, said Prahl. But in his view, the value premium arises because there are investors who are concerned about this pro-cyclicality, do anticipate needing to sell holdings during a downturn, and are, therefore, more likely to shun value stocks. "And this explains why value stocks historically have produced higher returns despite the fact that they are not, in an absolute sense, any riskier than growth stocks."

So, whether growth is more risky than value or less, it is in one sense more "conservative." That is, during an economic downturn, it is likely to suffer less than value. So, for investors who anticipate having to raise cash during periods of economic weakness, these stocks should hold particular appeal.

Given that the economy is widely expected to continue muddling through over the intermediate term and that certain risks continue to loom on the horizon—whether in the form of defaults in Europe, turmoil in the Middle East, or budget difficulties in the United States—the value of growth should be clear.


1 Richard Bernstein, Style Investing (John Wiley & Sons, 1995).
2 Ibid.
3 The Russell 3000® Growth Index measures the performance of those Russell 3000® Index companies with higher price-to-book ratios and higher forecast growth values.
4 The Russell 3000® Value Index measures the performance of those Russell 3000 Index companies with lower price-to-book ratios and lower forecast growth values. The stocks in this index are also members of either the Russell 1000® Value or the Russell 2000® Value indexes.
5 Y. Xing and L. Zhang, "Value versus Growth: Movements in Economic Fundamentals," working paper, University of Rochester, August 2004; cited in Mary Fjelstad and Dave Hintz, "Surviving U.S. Recessions with Style," Russell Investments, May 2009.
6 Mary Fjelstad and Dave Hintz, "Surviving U.S. Recessions with Style," Russell Investments, May 2009.

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