Market Commentary | March 22, 2021

It's What You Value … and Where You Find It

It’s What You Value … and Where You Find It

Key Points

  • It’s important to differentiate between the factors of growth and value and the index constituents of Growth and Value; i.e., lowercase g and v vs. uppercase G and V.

  • Investors can often find value within Growth indexes; while value traps can sometimes be found within Value indexes.

  • Since the market’s pandemic low a year ago, performance among styles can be broken into two key phases; the second kicking in on September 2, 2020.

I am often asked by investors why we do not have formal tactical views on growth vs. value like we do on large caps vs. small caps. The reason can be summed up by noting that there is a difference between the factors or characteristics of growth vs. value and the index constituents of growth vs. value. I often put it another way: there is a difference between growth and value (lower case g and v) and Growth and Value (upper case G and V). Let’s take a closer look.

Given the heightened focus on, and interest in, passive (or index) investing, discussing growth and value tends to lean toward the Growth and Value indexes vs. the factors of growth and value. Both S&P and Russell have Growth and Value Indexes; with Russell further breaking them into large cap (Russell 1000 Growth and Russell 1000 Value) and small cap (Russell 2000 Growth and Russell 2000 Value). Most institutional style-oriented products are benchmarked to the Russell style indexes; as such, they are generally considered the “industry standard.”

Below is a visual representation of the sector components of each of the aforementioned style indexes. For the benefit of apples-to-apples comparisons—and because S&P’s sectors are so well-known—we used S&P’s sector classifications and then applied them to the Russell indexes (which uses different segmentations across industries/sectors). I will refer to these pies throughout this report.

032221_growth sector weights
032221_value sector weights

Source: Charles Schwab, Bloomberg, iShares. S&P weights are as of 3/19/2021 and Russell weights are as of 3/18/2021.

Rebalancing methodologies

Russell rebalances its style indexes in late-June every year. The company use three parameters to classify stocks into its four style indexes: price-to-book ratios, five-year sales growth, and forward earnings estimates. There can be overlap among Russell’s four main style indexes; although the company also has “pure” growth and value index versions.

Because Russell aims to keep the total market cap of its standard growth and value indexes the same, the number of stocks in each index can differ. In fact, following the June 2020 rebalancing, the Russell 1000 Growth Index had its greatest concentration—i.e., the smallest number, at 435—of companies since at least 1995; while the Russell 1000 Value Index had one of the highest number of stocks ever at 838. In other words, there has become a highly-focused subset of growth companies taking up a much larger share of cap-weighted indexes.

S&P rebalances its style indexes in early-December every year. S&P’s growth factors are the three-year net change in earnings per share, three-year sales per share growth and price momentum. S&P’s value factors are the book value-to-price ratio, the earnings-to-price ratio and the sales-to-price ratio. As with the Russell indexes, there is overlap in terms of companies in the S&P Growth and Value Indexes; while S&P also has separate “pure” growth and value index versions.

Staying with the S&P indexes given our greater access to its data, the number of stocks in each index has generally increased over the past two decades, as shown in the charts below; however, the number of growth stocks has been in decline over the past six years since the peak in 2014.

Growth Stocks’ Descent

032221_sp growth number of stocks

Source: Charles Schwab, Bloomberg, as of 2/28/2021. For illustrative purposes only.

Value Stocks’ Ascent

032221_sp value number of stocks

Source: Charles Schwab, Bloomberg, as of 2/28/2021. For illustrative purposes only.

Importantly though, the number of stocks reflecting actual qualities of the factors has fallen substantially. There are presently 233 stocks in the S&P Growth Index, but only 80 stocks that have a standard growth characteristic of five-year average sales growth above 15%. Conversely, there are 436 stocks in the S&P Value Index, but only 94 S&P stocks that have a standard value characteristic of five-year average price-to-sales below 1.0.

Fewer “Actual” Growth Stocks

032221_sp 500 number of growth stocks

Source: Charles Schwab, Bloomberg, as of 2/28/2021. Growth stocks are defined as those with 5-year average sales growth above 15%.

Fewer “Actual” Value Stocks

032221_sp 500 number of value stocks

Source: Charles Schwab, Bloomberg, as of 2/28/2021. Value stocks are defined as those with 5-year average price-to-sales below 1.

As such, at least until the recent pickup in relative performance by Value indexes, the scarcity of actual growth characteristics was likely a factor in the outperformance of Growth over Value. Speaking of the recent pickup in relative performance by Value indexes, below are relative performance charts for both the Russell and S&P indexes. In the case of the large cap growth indexes—S&P Growth and Russell 1000 Growth—the peak in outperformance occurred on September 1, 2020 (pay attention to that date later in this report). In the case of the small cap growth index—Russell 2000 Growth—the peak in outperformance occurred a bit earlier on July 9, 2020.

Large Cap Growth vs. Large Cap Value

032221_r1000 growth v value

Source: Charles Schwab, Bloomberg, as of 3/19/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.  Past performance does not guarantee future results. 

Small Cap Growth vs. Small Cap Value

032221_r2000 growth v value

Source: Charles Schwab, Bloomberg, as of 3/19/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.  Past performance does not guarantee future results. 

S&P Growth vs. S&P Value

032221_sp 500 growth v value

Source: Charles Schwab, Bloomberg, as of 3/19/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.  Past performance does not guarantee future results. 

More than just semantics

When I summarize our views on growth and value and why they differ from a more generic (or index-based) approach, I often use examples. My examples generally use S&P’s indexes for illustration because, as mentioned above, we have more comprehensive access to historical valuation data from S&P than from Russell. 

My first example dates back to late-2002. After the tech bubble burst in March 2000, it led to a 57% decline in the S&P 500, a 78% decline in the NASDAQ and an 83% decline in the tech-heavier NASDAQ 100. Those declines experienced their finale in October 2002. For value factor-oriented investors who wanted to find deeply-undervalued opportunities at that time, they would have found them in both the growth and value indexes.

Many of the most-crushed Tech stocks were trading at deeply-undervalued prices—yet many of them were also still “housed” in Growth indexes. At the overall market’s bottom in October 2002, the forward P/E of the Tech stocks within the S&P Growth Index was 20.5. On the other hand, the forward P/E of the Tech stocks within the S&P Value Index was 25.6. In other words, many of the cheaper Tech stocks were actually in the S&P Growth Index; not in the S&P Value Index. 

It is worth noting that as the market deteriorated into the October lows, some Tech stocks made their way over to the S&P Value Index (given the “as-needed” rebalancing S&P conducts from time to time based on various factors). However, some were still present in Growth and, notably, they had much heftier weightings in the Growth Index than they did in Value.

As mentioned, our Russell valuation and weighting data is quite limited, but one point worth noting is that—due to Russell’s lagged rebalancing—there was a much higher concentration of Tech stocks still found in the Growth Index in October 2002. Thus, again, buying just Value didn’t necessarily mean buying (lowercase v) value.

Let’s fast-forward to the Global Financial Crisis (GFC) era for another example. At the March 2009 overall stock market low, Financials (which was the worst-performing sector during the crisis) had become the deep value play given the sector had fallen 83% from its pre-GFC peak. While it was true that the forward P/E of Financials within the S&P Value Index (8.7) was less than that in the S&P Growth Index (10.8), there are other things to consider from that time:

  • Real Estate Investment Trusts (REITs)—which were the second-worst performing sector during the GFC—were trading at an average 15.5 forward P/E in the S&P Growth Index vs. an average 25.2 forward P/E in the S&P Value Index. 
  • Consumer Discretionary stocks were trading at an average 14.9 forward P/E in the S&P Growth Index vs. an average 18.4 forward P/E in the S&P Value Index.
  • Tech stocks were trading at an average 12.8 forward P/E in the S&P Growth Index vs. an average 15.2 forward P/E in the S&P Value Index.

In other words (as was the case for Tech in late-2002), many of the cheaper REIT, Consumer Discretionary and Tech stocks were actually housed in the S&P Growth Index, not in the S&P Value Index.

There are a few more-recent examples I like to share. Utilities is a sector on which we currently have an “underperform” tactical rating. Obviously, the sector represents only a tiny fraction of growth indexes; but around 4-5% of value indexes. Utilities’ valuations have been driven up in recent years as investors were reaching for yield during the recent era of record-low interest rates. In other words, Utilities are still mostly housed in value indexes, but they don’t offer much actual value today. This phenomenon is often referred to as a “value trap.” 

In addition, a characteristic of this year’s market behavior is that value leadership broadly has been led by lower-quality groups of stocks—including non-profitable Tech stocks, weak balance sheet stocks, and heavily-shorted stocks (with GameStop having become the poster child of that particular cohort). These types of stocks often do well in the early stages of economic accelerations out of recessions. However, the risk/reward profile of these lower-quality cohorts is now leaning more toward the risk end of the spectrum given that the coming acceleration in economic data is likely largely priced in.

Chicken-or-egg

As noted above in the pie charts, there are distinct differences in sector weights within the various style indexes. As such, major moves in sectors can have an outsized influence on style performance. This is especially the case when looking at the pandemic era and breaking it into two distinct phases. Phase 1 was from the market’s low on March 23, 2020 through September 2, 2002. Phase 2 is the period since September 2, 2020.
The breakpoint of September 2, 2020 was the initial date of the S&P 500 and NASDAQ hitting fresh all-time highs. It was also the date that the 2020 year-to-date relative outperformance of the “big 5” (the largest five stocks in the S&P 500: Apple, Microsoft, Amazon, Google and Facebook) peaked relative to the other 495 stocks in the index, as seen in the chart below. On that date, the average year-to-date performance of the Big 5 was 65%, while the other 495 stocks were up only 3%. 

Big 5’s Dominance Has Ebbed

032221_big 5 spread

Source: Charles Schwab, Bloomberg, as of 3/19/2021. Big 5 stocks include Alphabet (Google), Amazon, Apple, Facebook, and Microsoft. Past performance is no guarantee of future results.

During Phase 1, the best performing sectors were Technology (housing Apple and Microsoft of the Big 5) and Consumer Discretionary (housing Amazon of the Big 5); as you can see below. Given that those represent much larger shares of the Growth indexes (see pie charts above), Growth had been outperforming Value. Those two sectors currently account for about 60% of the large cap S&P Growth and Russell 1000 Growth Indexes; and about 35% of the small cap Russell 2000 Growth Index. That’s in contrast to only 17-20% for the three Value indexes.

Phase 1 Sector Performance

032221_sector performance march 23

Source: Charles Schwab, Bloomberg, as of 3/19/2021. Past performance is no guarantee of future results.

Also of note is that Tech represents a much larger share of the S&P Growth and Russell 1000 Growth indexes than the Russell 2000 Growth Index. That bias also explains why large-caps were outperforming. In other words, the “narrative” during Phase 1 was that large cap growth was outperforming; but the nuance was that Tech and Consumer Discretionary were outperforming, which was to the benefit of large cap growth indexes; i.e., a chicken-or-egg situation.

Since Phase 2 began on September 2, 2020, it’s been an entirely different story. Since then, the best performing sectors have been Energy and Financials, as seen below. The combination of those two sectors account for only 2-4% of the three S&P and Russell Growth indexes; yet they account for 26% of the large cap S&P Value and Russell 1000 Value Indexes; and an even loftier 32% of the small cap Russell 2000 Value Index (of which nearly 27% is Financials). In other words, the “narrative” since Phase 2 began has been that small cap value has been outperforming; but the nuance is that Energy and Financials have been outperforming, which has been to the particular benefit of the small cap value index; i.e., a chicken-or-egg situation.

Phase 2 Sector Performance

032221_sector performance sept 2

Source: Charles Schwab, Bloomberg, as of 3/19/2021. Past performance is no guarantee of future results.

In sum

We believe investors should focus on the factors/characteristics of growth and value. There are times, especially after major market downturns, that value can be found in both the value and growth indexes. At the same time, the concept of “value traps” means that just because a stock is housed in a value index, doesn’t mean it offers compelling value. Given still-lofty valuations in general—even with the improvement in overall S&P 500 earnings (the denominator of P/E)—we believe investors should keep a close eye on (lowercase v) value but not necessarily only look for opportunities within (uppercase V) Value indexes.

In addition, as shown in the pie charts at the beginning of this report, whether you’re a sector-oriented or style-oriented investor, it’s important to understand the interaction between the two; with the moral of this story being know what you are buying.

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