Bridging the Gap | A Benefit of Diversification
Growth investments, also referred to as momentum investments, are comprised of companies whose earnings are expected to grow at a faster rate than the market. These investments can deliver impressive revenue and earnings gains, notwithstanding weak economic growth. On the other hand, strong relative performance for value investments might require more robust economic growth and higher interest rates.
Financial companies, as an example, account for a big chunk of value indexes. They would benefit from a stronger economy, which would in turn improve the credit quality of loan portfolios. Also, higher rates would widen the industry’s depressed interest rate margins.
According to Barron’s, momentum investments are now trading at an extreme premium to value investments with the valuation spread the highest since 1980. The past decade has been more kind to Growth than Value. Value stocks, underpriced relative to corporate fundamentals, have trailed the broad market as investors embraced growth stocks such as the so-called FANGs (Facebook, Amazon, Netflix, and Google). According to Barron’s, these highfliers powered the Russell 1000 Growth Index to a 5.7% total return last year. That was nine percentage points higher than the Russell 1000 Value Index, marking the widest performance gap since 2009.
This brings up an interesting dilemma. Are growth investments becoming too rich? Are Value investments too cheap to ignore? Growth has now out performed Value for nine years in a row. Why are Value portfolio managers so encouraged by this prior period of growth outperformance? They are encouraged because during periods after both the “Nifty Fifty'' market of 1966 -1973 and the “Technology Bubble” of 1998-1999, value investments showed strong performance, including seven straight years of value outperformance from 2000 to 2006.
For me, it always comes back to the same conclusion, asset allocation and diversification. Asset allocation and diversification means that you don’t exclusively have to own one or the other. You can own both growth and value investments hand in hand. It is extremely difficult, almost impossible, to predict which asset class will outperform the other and there may not be an absolute advantage to any single approach to investing over a long period of time.
Instead of choosing only one approach, diversifying between the two allows investors to strive for the best possible returns while managing risk by combining both approaches. This will ultimately allow investors to potentially gain throughout economic cycles in which the general market situations favor either the growth or value investment style.