There is no holy grail in investing. That’s why the “growth vs. value” argument for individual stocks has continued for decades without a clear winner. Here are the statistics.
We can use 4 simple indexes to look at growth vs value:
- Russell 2000 value index (small cap value stocks).
- Russell 2000 growth index (small cap growth stocks).
- Russell 1000 value index (large cap value stocks).
- Russell 1000 growth index (large cap growth stocks).
Value beats growth over an extremely long time frame. From 1979-2017…
- Small cap value outperformed small cap growth by approximately 3.2% per year!
- Large cap value outperformed large cap growth by approximately 0.8% per year.
Why is value’s outperformance so different when you look at large cap vs small cap?
Many small cap “growth stocks” are fly-by-night successes that fizzle out when the next recession hits or when industry trends change. These once-high flying growth stocks weigh down on the growth index’s multi-decade performance.
But here’s the more important point:
- Growth stocks tend to outperform when the entire stock market (e.g. S&P 500) is in a bull market.
- Value stocks tend to outperform when the entire stock market (e.g. S&P 500) is in a bear market or trending sideways.
This point is logical and can be backed up by historical facts. That’s why the Stock Picking Model:
- Predicts whether the broad stock market’s (S&P 500) trend is UP or down.
- Tells you to buy high growth, large cap stocks when the trend is UP.
Why growth stocks outperform value stocks during bull markets
Many value investors fail to realize this fact: growth stocks usually outperform in a bull market, regardless of how “overvalued” the individual stock is. In fact, some “overvalued” stocks become even more overvalued simply because the stock price is going up. People buy simply because other people are buying.
There is no point in getting mad or upset at “overvalued” stocks for leading the stock market’s rally during a bull market. There’s no point in arguing why this “shouldn’t happen”. The market doesn’t care what you or I think “should” or “shouldn’t happen”. That’s just how the markets work.
Growth stocks lead during broad index bull markets because the majority of investors EXTRAPOLATE that strong earnings growth into the future. For example, companies like Facebook, Google, and even Uber (a private company) have been “overvalued” for most of their life (if you use standard valuation analysis).
But investors continued to pay high valuations precisely BECAUSE these companies have high earnings growth. Investors extrapolated this high earnings growth into the future and say “Stock XYZ might be overvalued now, but at the rate it’s growing, it’ll be fairly valued in a few years”.
This kind of future-thinking dominates the mentality of the majority of investors during bull markets. This kind of thinking becomes a self-reinforcing cycle.
- Growth stock XYZ experiences significantly above-average growth for a long period of time (i.e. a few years).
- Investors bid up these stocks because despite being overvalued, “these companies will be reasonably valued in a few years if they continue growing at this rate”.
- The stock will continue to be bid up and “overvalued” as long as the company can maintain above-average rates of earnings growth.
Valuations only matter during bear markets. The most overvalued stocks also fall the most when the broad stock market (e.g. S&P 500) is in a bear market. This makes sense. Bear markets are about “mean reversion” for the entire stock market, and the most overvalued stocks will mean revert the most (i.e. fall the most) during bear markets. Hence, value stocks outperform growth stocks by falling less during bear markets.
This chart demonstrates my thesis:
- Look at 2008, a year in which the broad stock market (S&P 500) was in a bear market. Value indexes outperformed, and growth indexes underperformed. (Value fell less than growth).
- Look at 2009-2018, which were bull market years for the entire stock market. Growth indexes had the highest returns for 7 out of 10 years. Value indexes had the worst performance for 8 out of 10 years.
This doesn’t mean that growth stocks don’t underperform from time to time during equity bull markets (e.g. 2009-2018). Growth stocks tend to be high beta stocks, which means that they fluctuate more than the broad index.
- High beta stocks (e.g. growth stocks) rally more when the entire stock market is rallying.
- High beta stocks (e.g. growth stocks) fall more when the entire stock market is making a correction.
But since rallies last longer than corrections during bull markets, growth stocks outperform value stocks for the majority of the broad equities bull market.
We can see this with examples of individual stocks. Tech stocks have consistently experienced above-average earnings growth over the past 10 years. This means that despite consistently “high valuations”, high-growth tech stocks have outperformed low-growth stocks from 2009-2018 because the entire stock market is in a bull market.
Amazon has been consistently overvalued via traditional valuation analysis. But because:
- Amazon has above-average growth, AND…
- The broad stock market is in a bull market…
- Facebook has above-average growth, AND…
- The broad stock market is in a bull market…
Facebook has vastly outperformed the broad stock index over the past 6 years even though there were periods of time in which Facebook underperformed.
Netflix has been consistently overvalued via traditional valuation analysis. But because:
- Netflix has above-average growth, AND…
- The broad stock market is in a bull market…
Netflix has vastly outperformed the broad stock index over the past 6 years even though there were periods of time in which Netflix underperformed.
Yes, these high-growth tech stocks experienced bigger corrections than low-growth stocks, but they outperformed over the course of the entire equities bull market.
*Make no mistake: these stocks will also fall the most during the next equities bear market. Valuations matter during bear markets.
Low growth stocks and sectors underperform during bull markets. These charts demonstrate that utilities and real estate are expected to have the weakest earnings growth in 2018 and 2019. Hence utilities and real estate stocks are underperforming.
Notice how the utilities sector (XLU) has underperformed the S&P 500 over the past 5 years.
Notice how the real estate sector (XLRE) has significantly underperformed the S&P 500 over the past 5 years.
So the bottom line is simple
During equities bull markets: high growth stocks (and sectors) tend to outperform, low growth stocks tend to underperform.
Why investing in large cap growth stocks is better than small cap growth stocks
The Stock Picking Model only looks at the 50 stocks in the S&P 500 Index with the largest market cap. In other words, the Model only looks at the stocks in the top 10% in terms of market cap.
As I’ve already mentioned, value stocks tend to significantly outperform growth stocks over the extremely long term (i.e. multi-decade). This is because smaller cap growth stocks weigh down on the performance of growth indexes over the long term.
- Smaller cap growth stocks aren’t well established in their industry. This means they have a greater risk of long term business failure. (E.g. remember Groupon? Remember Zynga? Remember Chipotle?)
- Smaller cap growth stocks are much more volatile than large cap growth stocks. Small cap growth stocks often soar or crash on earnings reports. The gap ups and gap downs are massive.
Why Invest in 10 Growth Stocks Indiscriminately
As you can see, the Stock Picking Model puts 10% of the portfolio in each of the top 10 growth stocks.
The Model diversifies because any single stock faces a high degree of company-specific risk. Look at Tesla as an example: there are real bankruptcy fears, which is why Tesla has underperformed from mid-2017 to present. But taken as a group, these high-growth stocks aren’t that impacted by any single company’s risks.
It’s hard to consistently and accurately pinpoint which EXACT company will outperform. That’s why the Stock Picking Model isn’t really “guessing” which stock will outperform. It isn’t really trading individual stocks. It’s trading the CONCEPT that growth stocks will outperform during a bull market. Diversifying the portfolio among 10 stocks allows the Model to carry out this concept.
That’s also why the model makes each position size equivalent (10% per stock). It’s extremely hard to consistently and accurately predict which of those 10 stocks will outperform the most, so the Model doesn’t discriminate when allocating position sizes.
Advantage in buying high-growth stocks vs. leveraged ETFs during bull markets
All of my models so far trade SSO or UPRO, the S&P 500’s leveraged ETFs. This Stock Picking Model is different in that it doesn’t use leverage.
Individual stocks don’t lose value to ETF erosion. So unlike my other trading models, the Stock Picking Model does not face the risk of ETF erosion. It’ll be interesting to see if this Stock Picking Model beats a 2x leveraged S&P 500 ETF strategy over the long run. I’ll post weekly updates here on the blog.