Is There Value in Growth?

value investing orientation might be likened to home. It's sometimes boring, but it's where we're from and the place we return to. Growth investing, to continue the metaphor, might be compared to "vacation". It's exciting. It's fun. But, it eventually ends. And like the returning prodigal son, growth eventually returns home to value.

While this analogy probably overstates the dichotomy between these two fundamental investment paradigms, it is the case that the differences between growth and value can be significant.

This study makes a comparison of these two approaches - growth and value - over the past eight years (1995-2002). The data for this study were culled from Morningstar's Principia Pro software and eventually included 166 large-cap U.S. equity funds; 101 which were growth-oriented and 65 with a value-orientation. The funds which made it into the analysis had to have five years of performance data as of 12/31/02 and have at least 90% of their portfolio in U.S. stocks. In addition, only funds with the same manager(s) during the prior 5 years (1998-2002) were included. Among funds with multiple share classes only the primary share class was included (typically the fund with the largest net assets). Morningstar refers to this filter as "Distinct Funds". Finally, equity index funds were excluded.

Let's first examine the differential in portfolio median market capitalization among large cap growth funds (LG) and large cap value funds (LV) as shown in Figure 1. It's instructive to note that LG funds and LV funds had comparable market cap during 1995-97. In 1998, the median market of LG funds jumped, on average, by nearly 92% to $43.6 billion. LV funds, on the other hand, increased by "only" 38% to $23.3 billion. In 1999, median market cap among LG funds increased another 53% to an average of nearly $67 billion. Median market cap among LV funds averaged about $26 billion in 1999, representing an increase of less than 12% from the prior year. In the year 2000 market cap among LV funds increased by over 27%, while market cap among LG funds declined by over 12%. From the peak in 1999 to the end of 2002, market cap among this set of 101 LG funds fell by nearly 50%. Over the same time period, median market cap among 65 LV funds declined by just over 2%. The significantly less volatile fluctuations in median market cap among the LV funds suggests that a value orientation is inherently more stable and, if you will, represents more of an equity "home-base" than growth funds.

Also included in Figure 1 (and each subsequent figure) are annual data for the Vanguard 500 Index (the largest publicly available proxy for the S&P 500 Index). The S&P 500 is typically defined as a blend of both growth and value stocks.

Figure 1. Portfolio Median Market Cap

The median market cap for the S&P 500 is higher than either the growth or value fund averages. Inasmuch as large cap funds can have wide ranges in market cap this finding is not surprising. However, it does provide initial evidence that the S&P 500 is more oriented toward growth than value.

Let's look now at two of the more traditional variables that distinguish growth funds from value funds, namely Price to Earnings Ratio (P/E) and Price to Book Ratio (P/B). P/E data are shown in Figure 2. As anticipated, P/E ratios among growth funds are consistently higher than those of value funds. Between 1995 and 1999 the average P/E among growth funds increased by over 76%. By comparison, P/E ratios among value funds increased by only 45%. From the peak in 1999, the average P/E for this group of growth funds had declined by nearly 32% by 2002. The P/E for value funds declined by less than 14% over the same three year period. As shown in Figure 2, the S&P 500 Index followed a pattern more similar to growth funds.

Figure 2. Portfolio Price to Earnings Ratio (P/E)

Price to book ratios, as shown in Figure 3, reveal even more clearly the growth orientation of the S&P 500 Index over the past 8 years. Also shown are the significant increases in P/B among growth funds from 1997 to 1999. In just two years, average P/B among these 101 growth funds increased by over 72% whereas value funds saw P/B ratios increase by less than 22%. As was the case among P/E ratios, P/B ratios fell dramatically among growth funds (and the S&P 500 Index) during 2000, 2001, and 2002. Value funds also experienced a decline, but by one-third less than growth funds.

Figure 3. Portfolio Price to Book Ratio (P/B)

Finally, Figure 4 reports the total return for growth funds, value funds, and the S&P 500 Index. This gets interesting. Observe that average annual returns for the 101 growth funds and the 65 value funds were essentially identical during 1995, 1996, and 1997. It was during these three years that median market cap for growth and value funds were nearly identical as well (Figure 1) despite the fact that P/E and P/B ratios were different (Figures 2 & 3). However, despite the differences in P/E and P/E in 1995-1997, the variance (or differential) in P/E and P/B was relatively constant from year to year. It wasn't until 1998 that the returns of growth and value parted ways. Coincidently, in 1998, the differentials in median market cap, P/E, and P/B between growth and value funds began to widen.

In 1998, the average return among the growth funds was 33.31%. Value funds had an average return of 12.91%. In 1999, the differential in return between growth funds (36.7%) and value funds (4.89%) was in excess of 3,100 basis points. In 2000, the average return of this sub-set of growth funds plummeted to -11.2% while the value funds in this study had an average return of 9.97%. 2001 and 2002 proved to be a challenging environment for both growth and value, though value funds fared better.

As shown in Figure 4, the annual returns of the S&P 500 Index track much more closely with growth funds than with value funds. In fact, the correlation coefficient between the annual returns of the S&P 500 Index and the growth funds during this eight year period was 97% (where 100% represents perfect correlation). By contrast, the returns of the S&P 500 had an 87% correlation with the annual returns of the value funds.

Time to summarize. Based upon the annual returns and median market cap of actual funds, the "value vs growth" debate was essentially irrelevant during 1995-1997, despite the characteristic differences in P/E and P/B between the two camps. During 1998 the debate gained new fodder as growth funds distanced themselves from value funds in each of the four measures (P/E, P/B, median market cap, annual total return). It's worth noting that the S&P 500 Index clearly followed the pattern of the growth funds.

Figure 4. Annual Total Returns

In 1999, the gap between value and growth funds widened to its largest point. Growth funds had portfolio P/E ratios averaging above 40, while value funds were around 25. Price to book ratios among growth funds were in the range of 12, while value funds had P/B ratios around 5. In 1999, median market cap among large cap growth funds was nearing $70 billion, while large cap value funds averaged under $30 billion. Amazingly, just two years earlier, the median market cap between growth and value funds was very similar. Lastly, as already noted, the annual return differential between growth and value funds in 1999 was staggering.

Beginning in 2000, and continuing through 2002, the variance between growth and value funds (as measured by P/E, P/B, median market cap, and total annual return) began to diminish, though the differences continued to be large in 2000 and 2001.

By the end of 2002, the difference in aggregate P/E and P/B between growth and value funds had returned to a level comparable to what was observed in 1995. The huge gap in median market cap between growth and value funds had shrunk considerably to a differential of just over $10 billion. Lastly, in 2002, the annual returns of growth and value funds (and the S&P 500 Index) were much more closely aligned, albeit all were in the tank together.

Over the eight year period from 1995-2002, large cap value funds and large cap growth funds started and finished in similar fashion (or relatively close). It was during the middle years (1998-2000) that the differences were large. Growth funds, much like the prodigal son, are susceptible to extreme behaviors while away from their "value" home. In this case, extremes in annual return were seen among growth funds, both on the upside and downside.

Is there value in growth funds? Certainly. But the risks in straying too far from home should be evident by now.