The value vs growth debate is as old as investing itself. Which is best, value or growth? When is the best time to invest in value stock mutual funds? When is the best time to invest in growth stock mutual funds? Is there a smart way to balance both value and growth in one mutual fund? What happens to the debate when we enter index funds into the comparison?
Definitions of Value, Growth & Index Stock Funds
- Value stock mutual funds primarily invest in value stocks, which are stocks that an investor believes are selling at a price that is low in relation to earnings or other fundamental value measures.
- Growth stock mutual funds primarily invest in growth stocks, which are stocks of companies that are expected to grow at a rate faster in relation to the overall stock market.
- Index stock funds seek to mimic the price movement of a particular index, which is a sampling of stocks or bonds that represent a particular segment of the overall financial markets. For example, the Standard & Poor’s 500 (S&P 500), is an index representing roughly 500 of the largest US companies (large-cap stocks), such as Wal-Mart, Microsoft and Exxon Mobil. This article will also analyze the S&P Midcap 400 (mid-cap stocks) and the Russell 2000 (small-cap stocks).
The Debate: Strategies and Comparisons for Value & Growth
There is no doubt that value stocks generally perform better than growth in certain market and economic environments and that growth performs better than value in others. However, there is no question that followers of both camps--value and growth objectives--strive to achieve the same result--the best total return for the investor.
Much like the divides between political ideologies, both sides want the same result but they just disagree with the way to accomplish that result (and they often argue their sides just as passionately as politicians)!
Value investors believe the best path to higher returns, among other things, is to find stocks selling at a discount; they want low P/E Ratios and high dividend yields.
Growth investors believe the best path to higher returns, among other things, is to find stocks with strong relative momentum; they want high earnings growth rates and little to no dividends.
Value vs Growth: Perspective on Returns
It is important to note that the total return of value stocks includes both the capital gain in stock price and the dividends, whereas growth stock investors must rely solely on the capital gain (price appreciation) because growth stocks do not often produce dividends. In different words, value investors enjoy a certain degree of "dependable" appreciation because dividends are fairly reliable, whereas growth investors typically endure more volatility (more pronounced ups and downs) of price.
Furthermore, an investor must note that, by nature, financial stocks, such as banks and insurance companies, represent a larger portion of the average value mutual fund than the average growth mutual fund. This oversize exposure can carry more market risk than growth stocks during recessions. For example, during The Great Depression, and more recently The Great Recession of 2007 and 2008, financial stocks experienced much larger losses in price than any other sector.
How Index Funds Compare to Value and Growth
Index stock funds are normally grouped into the "Large Blend" objective or category of mutual funds because they consist of a blend of both value and growth stocks. An index investor usually prefers a passive investing approach, which is to say that they don't believe the research and analysis required for active investing (neither value, nor growth independently) will produce superior returns that are consistently higher than that of the simple, low-cost index fund. Index investors may also believe that the blend of both value and growth attributes can combine for a greater result -- a "one plus one equals three" effect (or actually one-half value plus one-half growth equals greater diversity and reasonable returns for less effort).
10-year Performance Analysis: Value vs Growth vs Index
Now let's let the numbers do the talking and do a bit of analysis following the chart, which consists of annual total returns on a year-by-year basis from 2002 through 2011:
Category/Index 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Large Growth -27.64 28.66 7.81  6.71 7.05 13.35 -40.67 35.68  15.53 -2.46
LargeValue  -18.69 28.44 12.97 5.95 18.15 1.42 -37.09 24.13 13.66 -0.75
S&P 500 -22.10  28.69 10.88 4.91 15.79 5.49 -37.00 26.46 15.06 2.11
Mid-cap Growth -27.24 35.96 13.23 9.84 9.00  15.09 -43.77  39.11 24.61 -3.96
Mid-cap Value -13.25 33.85 17.85 8.82 15.87 0.83 -36.77 35.41 21.92 -3.96
S&P Midcap 400 -14.53 35.62 16.48 12.56 10.32 7.98 -36.23 37.38 26.64 -1.73
Small-cap Growth -27.88 45.54 12.41 6.02 10.81 7.59 -41.55 35.46 26.98 -3.55
Small-cap Value -10.12 42.38  21.14  6.40 16.27 -6.08  -32.24 31.32 26.17 -4.45
Russell 2000   -20.48 47.25 18.33 4.55 18.37 -1.57 -33.79 27.17 26.86 -4.18
All of the above are total returns. Data from Morningstar, Inc. Past performance is no guarantee of future results.
As you may have noticed, I've broken the chart into three sections -- the first is large-cap stock, the second is mid-cap stock, and the third is small-cap stock, each with its respective growth and value objective, in addition to its respective index. In each of the three sections (and under each calendar year), the best return for the particular section is in bold. For example, among large growth, large value and the large-cap index (S&P 500), large value has the best return (-18.69) for the year 2002.
Key Takeaways and Analysis Points for Performance Chart
- Value wins among large-cap, mid-cap and small-cap stock in 2002, which was a year that marked the end of the recession that followed the "dot com bubble." It is common for value to outperform growth and blend (index) during recessionary environments.
- Value wins in all three sections in 2004 but results are mixed in following years until we get to 2007, where growth dominates. It is also common for the growth objective to perform best in the latter stages of the economic cycle (the Great Recession began at the end of 2007). This is because the growth objective has a "momentum" effect -- as the economy strengthens, so does the growth objective returns.
- Growth loses to both value and index in 2008 when investors sold out of the perceived riskier areas; but growth stocks got a big bounce upward in 2009 where it dominated.
- There was no year where index dominated completely but the S&P 500 Index wins in the large-cap section in 2003, 2008 and 2011; the S&P Midcap 400 wins in 2005, 2008, 2010 and 2011; and the Russell 2000 beats small growth and small value in 2003 and 2006.
- When index wins, it typically wins by a narrow margin for large cap stocks but by a wide margin in mid-cap and small-cap areas. This is at least partially attributable to the fact that expense ratios are higher (and thus returns are lower) for the actively-managed funds represented by growth and value. This index out-performance for mid-cap and small-cap segments is also significant because many investors believe the opposite -- that actively-managed funds (not index) are best for mid-cap and small-cap stocks but passive investing (indexing) is best for large-cap stocks. For more in this point, see Efficient Market Hypothesis (EMH).
- Perhaps the most significant takeaway from this analysis is that no particular investment objective (growth, value or index) dominates as a whole during the 10-year period. Neither of the three spends more than four years or less than two years at the top of its respective capitalization section (large-cap, mid-cap or small-cap).
- I don't recommend market timing but the best time to invest in growth stocks is typically when times are good during the latter (mature) stages of an economic cycle (see 2007 column in chart) and the best time to invest in value stocks and index funds is during recession (see 2002 and 2008).
- Neither growth nor value investors can claim an outright victory here. However, index investors can claim that they may not often be the top performer but they are less often the worst performer during the period. Therefore, they can be confident in receiving at least average returns for an average to below-average level of market risk due to diversification and low costs.
A Few More Thoughts on the Value vs Growth vs Index Analysis
A important note to make here is that the year-by-year analysis is not as conclusive for an investor as annualized returns for a particular period. For example, the 10-year annualized total return winner (data as of 3/31/2012) for large-cap stocks is the S&P 500, with a return of 4.12%, compared to 4.04% for growth and 4.09% for value. This is a statistical tie, especially considering the expense ratio for the best S&P 500 index funds will trim off the return a bit lower.
However, the winner for 10-year annualized returns for mid-cap stocks, as of 03/31/2012, is the S&P Midcap 400 (11.02%) compared to Mid-cap Growth (7.99%) and Mid-cap Value (8.51%). For small-cap stocks, Small Value wins the 10-year contest with 9.25% return, compared 8.02% for Small Growth and 7.46% for the Russell 2000 Index.
With that said, the year-by-year analysis is a good visual that illustrates there is no consistent "winner" between value, growth and index funds. If you want to know which specific fund type is the overall winner in the years between 1997 and 2012 (15 years) check out this blog post: S&P Midcap 400: Best Index in 15 Years. Also, a good and basic reference for the growth vs value debate is this web article: "Growth" Versus "Value" Investing from Dows.com.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.