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Here’s why the smart money is betting on value stocks to outperform growth

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You should be skeptical of the growth story that periodically captures stock investors’ attention. That’s because the companies that Wall Street believes will grow the fastest in the future rarely live up to the lofty expectations investors put on them.

The latest of bout of this growth-stock fever occurred this week. On Wednesday, after Federal Reserve Chairman Jerome Powell hinted that the Fed would slow the pace of future rate hikes, investors jumped on the growth bandwagon. The SPDR S&P 500 Growth ETF
SPYG,
-0.29%

gained 4.3% in that day’s session, far outpacing the 1.9% return of the SPDR S&P 500 Value ETF
SPYV,
+0.02%
.
Meanwhile, Invesco QQQ Trust
QQQ,
-0.40%
,
which is heavily weighted with tech stocks that in essence are growth stocks on steroids, gained even more, 4.6%.

On the surface, investors’ reaction makes a certain amount of sense, since the present value of future years’ earnings increases as interest rates decline. Since a greater share of growth stocks’ earnings than value stocks’ earnings traces to future years, growth stocks should benefit disproportionately when rates decline.

Or so the growth stock rationale goes. The Achilles’ Heel of this rationale is the assumption that growth stocks’ earnings will actually grow faster than for value stocks. More often than not, this isn’t the case.

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This is difficult for investors to accept, since growth stocks are often those whose trailing years’ earnings growth has been well-above average. But just because a company’s past earnings have grown at a brisk pace doesn’t mean they will continue growing at that pace in the future.

We should actually expect that earnings will not be able to keep that pace, according to several major research projects over the past couple of decades. One of the first, which appeared 25 years ago in the Journal of Finance, was conducted by Louis K. C. Chan (chair of the Department of Finance at the University of Illinois Urbana-Champaign), and Jason Karceski and Josef Lakonishok (of LSV Asset Management). Upon analyzing data for U.S. stocks from 1951 through 1997, they found that “there is no persistence in long-term earnings growth beyond chance.”

Two researchers at Verdad, the money-management firm, recently updated this Journal of Finance study to focus on the 25 years since it was published. They are Brian Chingono, Verdad’s director of quantitative research, and Greg Obenshain, partner and director of credit at the firm. They reached the same conclusion as the earlier study: “[W]e found little to no evidence of persistence in earnings growth, beyond chance, over the long term,” they concluded.

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The table below summarizes what the Verdad researchers found for companies whose earnings growth in a given year were in the top 25%. They looked to see how many of them, on average, were in the top half for EBITDA growth in each of the subsequent five years. That’s a rather low bar over which to jump, and yet many, in some years most, failed to clear it.

% of top quartile of firms for earnings growth in a given year that are above median for EBITDA growth at… Expectation based on randomness/pure chance Difference from pure chance (in percentage points)
End of subsequent year 1 48.8% 50.0% -1.2
End of subsequent year 2 23.0% 25.0% -2.0
End of subsequent year 3 12.3% 12.5% -0.2
End of subsequent year 4 6.8% 6.3% +0.5
End of subsequent year 5 4.0% 3.1% +0.9

Note carefully that these results don’t mean that the overall stock market shouldn’t have rallied this week in reaction to the Fed’s expected pivot. Instead, these studies speak to the relative performance of value- and growth stocks. Growth shouldn’t outperform value just because interest rates may be falling, just as value shouldn’t outperform growth just because rates may be rising.

So keep this in mind the next time the Fed pivots. If the market reacts by skewing heavily towards either growth or value, a gutsy contrarian bet would be to predict that the reaction will soon correct itself. This is why contrarians right now are betting on value over growth.

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Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

Also read: Fed ‘pivot’ to lower interest rates will be bullish for stocks. But timing is everything.

Plus: The key word for investors to decipher the Fed’s next move is ‘moderation,’ strategist Ed Yardeni says.

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