home Latest News The Value-Growth Rotation Strategy That Has Beaten The Market For 40+ Years – Seeking Alpha

The Value-Growth Rotation Strategy That Has Beaten The Market For 40+ Years – Seeking Alpha

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(Source – Pexels/Alexander Dummer)

I’ve stumbled upon an interesting market phenomenon that could be quite profitable for long-term equity investors and has outperformed the market since 1978 by just over 2% per year with relative consistency.

Most of you have heard that value and growth investing tend to beat the market, but they very rarely outperform simultaneously. Following the incredible blowup of growth stocks at the turn of the millennium, value investing became very popular in the 2000s and outperformed by a wide margin. Of course, value investing tends to allocate more toward bank stocks which, like tech stocks years before, lost well over half of their value in 2008. Since then, growth has dominated the market and many today are claiming “value is dead“.

It would certainly seem so. If you bought high P/E ratio stocks like Apple (AAPL), Alphabet (GOOG) (NASDAQ:GOOGL), Amazon (AMZN), etc. in 2010, you’d likely to have achieved a nearly 10X return. Had you bought the likes of Buffett’s Berkshire (BRK.A) (NYSE:BRK.B) which has historically dominated the value space, you’d have essentially market-performance. Of course, if you go ten years back, the exact opposite would be true. If you bought Berkshire in 2000 and sold in 2008, you’d have made nearly 30% per year. Had you bought AMZN, you’d have a loss until 2011 with a 93% loss in 2000.

Of course, these are extreme examples, but they illustrate my point. The outperformance of value and growth switch every decade. In fact, they have been consistently switching off every decade since 1978 when the two style strategies were first measured.

Using this phenomenon, we can create a simple long-term investment strategy: At the turn of the decade, if growth outperformed the decade prior, buy value; if value outperformed, buy growth. Had you implemented this strategy from June 1978 to today with $1,000, you’d likely have just over $200,000 today. Take a look below:

(Data Source – Federal Reserve/Wilshire Value and Growth indices)

As you can see, this has been a dominant strategy that has delivered nearly twice the total performance of value investing and has far outpaced growth and simple buy-and-hold. Notably, growth has delivered no long-run outperformance.

Here are a few interesting statistics on this performance:

Strategy Annual Returns Annual Standard Deviation Sharpe Ratio
No Style (Wilshire 5000) 11.3% 17% 0.53
Growth 11.3% 21% 0.42
Value 11.9% 16% 0.59
Switch 13.3% 17% 0.63

As you can see, the “switch” strategy outperformed not only on an absolute basis but also on a risk-adjusted basis as seen in its superior Sharpe ratio.

For the remainder of the article, I’d like to dive a bit deeper into the strategy and talk about a few potential reasons that could explain its consistent outperformance.

The Value-Growth Supercycle

There is a well-known phenomenon in commodities trading called the “commodity supercycle“. Essentially, when commodity prices rise and speculation becomes rampant, producers expand their footprint and increase supply capacity. This eventually leads to extreme oversupply and a major crash occurs (like oil in 2015). Prices fall below production costs and high-cost producers (i.e., offshore drillers) go out of business. Eventually, this leads to a supply shortage and the cycle repeats.

I believe the “value to growth supercycle” has a very similar dynamic. Value investing tends to be a winning strategy, but when it goes on for too long, poorly run companies that deserve low valuations obtain medium-tier valuations and eventually surprise investors when they go bankrupt in a recession (i.e., banking/industrials in the 2000s).

After value investing fails and a generation of investors and financiers are effectively wiped out (1987, 2007), the next generation takes over and pursues the opposite strategy by buying hot growth stocks (1990s, 2010s).

After seeing every IPO deliver strong performance, they eventually believe everything “will be the next Facebook (NASDAQ:FB)/AOL” and push valuations to nonsensical levels. In the end, fundamentally flawed businesses achieve sky-high valuations. I would place pets.com (from dot-com bubble) and Chewy (CHWY) (today) in this category.

To illustrate, begin by taking a look at the log performance of large to small-cap value and growth investing since 1978:

(Data Source – Federal Reserve/Wilshire Value and Growth indices)

What I find interesting is that the best long-run performers are not necessarily the ones you’d expect. Small-cap growth has actually been the worst-performing strategy, while the small-cap value is best. Intuitively, it would seem that small-cap growth would outperform because they have more “growth potential” and small-cap value would underperform because they have weaker market share. Perhaps it is this common bias that causes the opposite to be true.

Now, if we combine the respective three value and growth indices together, we get the “value” and “growth” index that I showed in the first chart. Take a look at the rolling 10-year back returns of each investment strategy since 1983:

(Data Source – Federal Reserve/Wilshire Value and Growth indices)

As you can see, there tends to be a major market regime shift at the end of each decade. Everything rose together in the 90s, but growth dominated the end of the cycle. The opposite was true in the 2000s as value outperformed by a wide margin, but net returns in the decade were near zero. The 2010s have been much like the 90s with everything performing nearly the same, but growth dominating late cycle.

To make this super-cycle dynamic even more clear, take a look at the 5-year rolling returns of growth minus that of value as well as the 5-year rolling returns of “switch” minus the average rolling return of both growth and value:

(Data Source – Federal Reserve/Wilshire Value and Growth indices)

While the pattern of “growth vs. value” is certainly not a pretty sine wave, it does have the resemblance of one. It also implies that the great growth stock rally of the 2010s is likely to die over the coming decade as it did in the 2000s and 80s. Even more, while “switch” does not always outperform as greatly as it did in the 2000s, it very rarely underperforms either growth or value.

The Bottom Line

Interestingly, I tried to make a few “dynamic switching” type models that used market events (as opposed to the year) to switch between value and growth. For example, “if the market drops 30% then switch strategies” or “buy the worst performer over the past three years”. These strategies underperformed the simple “decade switch” strategy which leads me to believe that the alpha generated is truly due to the decade change.

While it may seem odd, it is a bit logical. We know that decades matter in our daily lives in the clothes we wear, habits we form, and political narratives we believe. As we leave the 2010s and enter the 2020s, many unexpected changes are likely to occur. One change that I do expect is for value to outperform growth.

There are abundant opportunities for value investing among U.S materials and industrials, as well as just about every international equity. I know people will find reasons to say I’m wrong, but it is nonsensical that U.S. Steel (X) trades at a TTM P/E of 3.8X while a more leveraged and lower profit margin Netflix (NFLX) trades at 95X (not to mention all of that debt being backed by intangibles). They are certainly in different lines of business, but from a financial standpoint, their bankruptcy risk is very similar and the gap is unjustified (particularly on NFLX’s side).

Today, with the economy at the tail end of its cycle, I’m looking mainly at market neutral strategies. It is a dangerous time to be long or short and a lot of alpha can be generated from pair trades as asset prices de-correlate.

Take a look at the performance of a “long value, short growth” pairs trade using the SPDR Portfolio S&P 500 Value ETF (SPYV) and the SPDR Portfolio S&P 500 Growth ETF (SPYG):

Note, by dividing the total return price of each, you can simulate the pair trade performance with daily rebalancing.

Chart Data by YCharts

As you can see, this strategy had a stellar performance streak in the early 2000s and has declined since 2008 but has been breaking out over the past few months. Right in line with the end of the decade.

It will be interesting to see if this phenomenon holds into 2020 and we see value outperform growth as expected. Today, value ETFs like SPYV look like a clear buy when compared to growth funds like SPYG which are probably short selling opportunities.

Disclosure: I am/we are long X. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.