When Comparing Growth to Value, Look Under the Hood

When investing, there are many different investment styles and factors for categorizing stocks.  Categorizations became especially popular when Morningstar created a style box to classify stocks.  Across the vertical axis of the Morningstar style box, stocks are categorized by size.  There are large cap, mid-cap, and small-capitalization stocks, which is based on the market capitalization of the stock (i.e. how big the company is).  On the horizontal axis stocks are categorized by style.  The three styles are value, blend, and growth.  Value stocks typically have low valuation multiples, such as P/E (price to earnings), P/B (price to book value), and P/S (price to sales).  Additionally, value stocks tend to have higher dividend yields.  Growth stocks, on the other hand, typically have strong future earnings and sales growth potential.  Due to this higher than average expected business growth they tend to command higher valuation multiples.  Blend stocks are stocks that do not exhibit strong value or growth characteristics, but instead possess some of each.

Over the years there has been great debate over which style of investing is better: growth or value.  Using the Morningstar categorizations, we can easily compare the two styles over different time periods and analyze how each performs.  After analyzing, we see that growth stocks have outperformed value stocks recently, but value stocks have outperformed growth in the long run.  So why has growth recently outperformed value?  For one, the sector composition of the growth and value indices plays a large part in the performance differential.  In this piece we will take a deeper dive into the sector composition within the growth and value indices and examine how this has played a part in growth’s recently outperformance.

For better or worse, recent performance is typically what investors focus on when analyzing investments.  Looking over the last 15 years, growth has absolutely dominated value.  Over the last 15 years the Morningstar Growth Index has returned a cumulative 364.54% compared to just 138.1% for the Morningstar Value Index.  The below shows the returns for both indices over the past 15 years, illustrating the vast outperformance of the growth index (in blue).

Not only has growth outperformed value over the past 15 years, it has also done so over the trailing 1, 3, 5, and 10 years.  The below shows the annualized return of each style for each, illustrating just have prevalent growth’s outperformance has been.

1 year-9.78%20.96%
3y annualized1.12%18.28%
5y annualized4.25%14.16%
10y annualized9.32%16.05%

While looking at cumulative performance can be telling, diving into the year by year performance can provide more specific detail into when one style outperforms the other.  The below shows the year by year returns of each index over the last 15 years.  As you can see, value stocks held up better in the 2008 Great Financial Crisis, but have pretty much lagged ever since, except for 2016. 

So why has growth has outperformed recently?  One reason is the sector composition of each.  By looking at the Vanguard Value ETF (VTV) and the Vanguard Growth ETF (VUG) we can compare the current sector breakdown within each style relative to the S&P 500 (VOO).  The below shows the absolute sector weights for VTV, VUG, and VOO.

In addition to looking at absolute weights, we can look at the weights of the growth and value indices relative to the S&P 500 to see where each is over or under weight. 

Lastly, we can compare the value index relative to the growth index to see how large the underweights/overweights really are.

As you can see from the above, the growth ETF is overweight technology, consumer cyclical, and communication services stocks, whereas the value ETF is overweight healthcare, financials, consumer defensive, utilities, and energy stocks.  This sector composition intuitively makes sense as technology, communication services, and consumer cyclical stocks tend to exhibit strong earnings and sales growth, whereas financials, healthcare, consumer defensive, and energy stocks typically pay out higher dividends and trade at lower multiples. 

After analyzing sector performance over the last 15 years it becomes clear that a major reason for growth’s recent outperformance is being overweight technology and consumer defensive stocks and underweight financials and energy stocks.  Over the past 15 years, technology stocks (represented by the Technology Select SPDR ETF: XLK) and consumer discretionary stocks (represented by the Consumer Discretionary Select SPDR ETF: XLY) have returned 505.54% and 363.39% respectively, whereas financial stocks (represented by the Financials Select Sector SPDR ETF: XLF) and energy stocks (represented by the Energy Select Sector SPDR ETF: XLE) have only returned 32.61% and 27.94% respectively. 

So why has the performance of these sectors been so disparate?  For one, the U.S. has experienced a period of low and falling interest rates.  This puts pressure on banks (financials) margins and makes it less profitable for them to borrow short and lend long.  Additionally, the past 15 years includes the Great Financial Crisis of 2008.  The GFC hit banks and financials the hardest, being a major reason for their underperformance.  Energy, on the other hand, underperformed due to the recent shale boom in the United States.  The discovery of fracking has led to cheap production of oil within the U.S.  This has put pressure on oil prices and has led to a long period of energy stock underperformance.  Technology and consumer discretionary stocks, on the other hand benefited from a long period of low interest rates, making it cheap for them to borrow capital to invest in their businesses.  This has led to strong earnings and sales growth, which has translated into strong stock prices. 

While growth has outperformed value over the past 15 years, when you expand the analysis to the past 20 years, value actually outperforms growth, even after factoring in the recent underperformance.  The below shows the performance of the indices going back to 2000 (value index in green, growth in blue).

Sector composition can also partly explain why value stocks have outperformed over the trailing 20 years.  The growth index was hurt at the beginning of the century by being overweight to technology stocks during the dot-com bubble of 1999/2000.  Leading up to the bubble, in 1999, the growth index strongly outperformed, however as the bubble popped, technology stocks were crushed, in turn crushing the growth index.  The value index, on the other hand, was somewhat able to avoid the dot-com bubble carnage by being underweight technology stocks.  By avoiding the major drawdowns at the beginning of the analysis, the value index vastly outperforms growth over the long run.  The below chart shows the performance of the Morningstar Value Index (green) and the Morningstar Growth Index (blue) during the dot-com bubble, illustrating how growth stocks severely underperformed value during this time.

The million-dollar question is whether high growth stocks continue their outperformance in the years to come.  While technology stocks seem to have the momentum and the trend behind them, over time things typically revert to the mean.  With growth’s recent outperformance, it would take a huge value rally to return to the mean.  The below shows the historical drawdown of growth vs value.  Value is currently in an over 50% drawdown vs. growth, which is the largest we have seen going back to the 1930s. 


While much digital ink has been spilled over the growth vs. value debate, not many take the time to look under the hood and compare the sector compositions within each.  The value index tends to be overweight financials, healthcare, and energy, whereas the growth index tends to be overweight technology, consumer discretionary, and communication services.  Will growth continue to outperform value in the years to come?  The answer to that question is anyone’s guess, but if it were to continue to outperform, it will most likely be because technology, communication services, and consumer discretionary stocks continue to lead the market.  If we were to see a “changing of the guards” where value outperforms growth, it will most likely be because financials and energy stocks start to outperform.  While broad categories such as growth and value are good for categorizing stocks, it is important to look under the hood and see the implicit sector bets you are making when investing in each.