Andrew Hallam is the index investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.
If value stocks were houses, they wouldn't have much curb appeal. Their paint might be peeling. Their fences might be battered. Their roofs might have moss growing on the asphalt shingles. But value stocks are cheap when measured by price-to-earnings or price-to-book multiples. They just aren't likely to boast the next hot tech gadget or promise a guaranteed cure for hair loss. So they don't usually gush with record business sales.
Growth stocks, by comparison, are like glitzy show homes. They aren't cheap. But they look great. As businesses, they often boast record earnings. Offering products of the future can make them red hot. Their whispered names spread through cocktail parties like a rumour through a middle school.
Value stocks, however, usually beat growth stocks. They don't do it every year. Nor do they do it every decade, so they test value investors' mettle. Growth beat value between 1990 and 1993. Fast-growing companies also beat value most years between 1995 and 2001. The same can be said over the past five years. Growth spanked value.
Unfortunately, too many investors fail the mettle test. They run from value stocks after a weak run. Or they leap into value when it's thumping growth. Such behaviour doesn't show sophistication. It shows foolishness. Nobody knows, with any level of consistency, which style will turn heads over the upcoming year or decade. Like teenagers following fashion, investors change clothes to fit the latest style. But they're often too late.
Between 1991 and 2013, the average value fund averaged 9.36 per cent a year. But as U.S. researchers Jason Hsu, Brett Myers and Ryan Whitby found, the typical investor in value funds averaged just 8.05 per cent. They underperformed the funds they owned by an average of 1.31 per cent a year.
Research Affiliates' Mr. Hsu and Vivek Viswanathan say that most value investors "chase trends, allocating away from value funds after a period of underperformance and towards them after a period of outperformance." In other words, they buy value stocks after they have beaten growth. And they buy growth stocks after they have beaten value. This backward forecasting gets expensive.
Research Affiliates found that growth stock funds averaged 8.38 per cent between 1991 and 2013. But by trying to time a hot investment style, the average investor in growth stock funds made just 5.22 per cent a year.
Instead of chasing tails, investors could do one of three things. Pick and stick to either value or growth. Or buy a total stock market index. This would represent equities on the entire stock exchange, giving exposure to growth and value stocks. Or an investor could rebalance a portfolio between growth and value stock market indexes. By rebalancing once a year, they could sell pieces of the winning investment style, adding the proceeds to the underperforming style.
David Koenig, investment strategist at Russell Investments, shows how it could work. To take advantage of the fact that value stocks usually beat growth, he recommended a portfolio of indexes made up of 60 per cent value stocks and 40 per cent growth stocks.
Such a combination, between 1987 and 2014, would have averaged 10.4 per cent a year. By comparison, a value index would have averaged 10.6 per cent. A growth index would have averaged 9.78 per cent. And the S&P 500 index earned a compounding average of 10.42 per cent. But if value and a broad stock market index both beat growth, why bother with growth? It's a fair question.
Unfortunately, most investors have a tough time sticking to a single style. Value investors, as Research Affiliates shows, often bail after a period of underperformance. Growth investors do likewise.
By owning a portion of each investment style, investors could curb their tendency to gamble on which one will outperform. They'll always own a piece of what's currently in vogue. Investors could buy the iShares Canadian Growth Index (XCG) and the iShares Canadian Value Index (XCV). Each trades on the Toronto Stock Exchange.
To split U.S. stocks between growth and value, investors could buy the iShares Core U.S. Growth ETF (IUSG) and the iShares Core U.S. Value ETF (IUSV). Each trades on the New York Stock Exchange.
No matter what your investment style, stick to a game plan. Those jumping from growth or value place foolish bets.
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Andrew Hallam