Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
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EQ: In this week’s Sector Watch report, you examined the differences between growth and value stocks on the S&P 500. Value investors tends to find bargain stocks, while growth investors don’t mind paying a little more for potential. Which strategy has paid off most for investors in recent years?
Stovall: We have found that both strategies have done exceptionally well. Over the past five years, the S&P 500 Pure Value components has posted a compound rate of growth of 25% versus 23% for the Pure Growth companies. But while Value beat Growth on the large-cap side, the Growth beat Value on the MidCap 400 and SmallCap 600 side.
But either way you slice it, by taking a pure approach—Pure Value or Pure Growth—you ended up significantly outperforming the overall benchmarks. So I think a lot of investors were very happy if they decided to lean excessively to the growth side or to the value side.
EQ: Interestingly, the S&P SmallCap 600 showed more value characteristics than the larger S&P 500 companies. When investors think of small-cap stocks, don’t they tend to think growth?
Stovall: I think that really depends because most people look to small-cap stocks as growthier than large-cap stocks because they come from a small base, and whatever growth that comes from the economy that translates to corporate earnings growth could therefore imply a much greater jump in earnings prices. So I would say that on average small-cap stocks have higher standard deviations and higher betas than large-cap stocks.
However, when we look to what we define as a growth company versus a value company, for growth, we look to three-year change in earnings per share over price per share, as well as three-year sales per share growth rate, and momentum of price over the preceding 12 months. For value, we look to your traditional book value to price ratio, earnings to price ratio, and sales to price ratio.
In that regard, we found that from a market-cap weighted basis, 36% of the S&P SmallCap 600 were deemed to be Value and 30% were deemed to be Growth. So it is interesting that we ended up having a little more on the value side than on the growth side. Whereas on the S&P 500, it was a little more evenly distributed with 35% was Growth and 33% was Value.
EQ: You identified certain ETFs that seeks to replicate the various Pure Style indices. Are there any rotational strategies to apply here, such as for a risk-on/risk-off market, or possibly a seasonal approach like the sell in May strategy with cyclicals and defensive sectors?
Stovall: I really haven’t looked into strategies, but based on the findings in my report, it may be better simply to take a 50% exposure to each. I haven’t come up with a consistent indicator to suggest when would be a good time to buy Pure Growth or a good time to buy Pure Value. My thought is to own a little bit of each and then that way, if one is in favor while the other is not, you still get the performance that has been significantly higher than its overall benchmark.
For instance, I looked at the total returns for a hypothetical portfolio of 50% S&P 500 Pure Growth and 50% S&P 500 Pure Value, which posted a compound rate of growth of 11.8% versus 8.1% for the S&P 500. This similar 50/50 split for the MidCap 400 was up 12.9% versus 11.6% for the index itself. Finally, for the SmallCap 600, the 50/50 split was up 11.5% per year versus the 10.3% for the small-cap benchmark.
EQ: Is the reason why a hybrid portfolio of 50% growth/50% value would outperform its benchmark because investors are eliminating the more stagnant components of the respective indices?
Stovall: I think that’s a good way of putting it. About a third of the overall index for each market cap segment doesn’t know whether it is growth or value. For the S&P 500, 33% of the components are categorized as Blend. The MidCap 400 has 36% and the SmallCap 600 has 35%. So a good one-third of each one of these indices contain both growth and value characteristics.
If an investor prefers to buy low and hopefully sell high, then they’re going to be aiming more toward the attractively valued Pure Value components. If, however, an investor would rather buy high and sell higher, they could lean toward the Pure Growth components. So for each style of investor out there, there is a style of slicing the overall benchmark. All you do is get rid of the split personalities, and since 1995, that has allowed investors to outperform the overall benchmarks.