A consequent theme of this bull market has been growth outperforms value. This is easily shown by simply comparing growth stocks versus value stocks. Both the S&P 500 Growth Index and the Russell 2000 Growth Index have averaged ~15% returns for the last 5 years. Their performance has exceeded both the S&P 500 Value (+9.7%) and Russell 2000 Value (+8.6%) indices by a considerable margin.
There have been several recent articles in the Wall Street Journal and other financial publications on this phenomenon. However, they all seem to miss what I believe is a very simple answer for this disparity in returns. In a recent article in Institutional Investor a senior investment professional stated she “doesn’t know why growth has outpaced value over the past ten years.”1 Forbes magazine recently gave several explanations such as “growth stocks have done better in bull markets when companies’ earnings are rising” and “value stocks usually do well in early stages in economic recovery.”2 However, every article I have read (and surely, I have missed a few) has failed to explain some simple mathematics.
When one is buying a security, one is presumably buying future cash flows. (Investors could also be buying a stock over some perceived discount to asset values but we will focus on cash flows.) Growth stocks are as the moniker implies growing and therefore will have larger earnings or cash flow in the future as opposed to another company that is growing more slowly. The traditional method of valuing securities is to calculate the present value of those future cash flows using a discounted cash flow model or DCF.
The formula every business student learns for this calculation is take the estimated cash flows, the period of time over which these cash flows will accrue and then reduce those flows by a discount rate or weighted average cost of capital (WACC). This cost of capital is largely driven by current interest rates. If the interest rate is high, then the future cash flows will be worth less than if the rate is low. Theoretically, if the discount rate is zero, then any future cash flows are worth the same today as they are in the future.
Today, we live in a world of very low or even negative interest rates. This serves to dramatically lower WACC when compared to the past. As a result, future cash flows are today (at least according to the DCF model) move valuable than ever. With this in mind it’s easier to see why growth stocks are out performing. In past years where US Treasury or the “risk free” rate was significantly higher, so was the discount rate, the value of future flows and hence the current value of any particular growth stock.
The low or close to zero risk free rate coincides directly with the bull market. From a purely mathematical perspective it is easy to see why growth throughout this period has outperformed value. And as long as interest rates remain low, it could be a very good bet that growth will on balance outperform value. Most of the articles I read fail to mention this very basic premise. Stock values change for all kinds of reasons and growth probably won’t always win out, the reason it has been winning is fairly easy to see, in our opinion.
- Julie Segal, “The Real Reason Value Has Been Lagging Growth,” Institutional Investor, October 24, 2019, https://www.institutionalinvestor.com/article/b1hqrt2pv2z0tl/The-Real-Reason-Value-Has-Been-Lagging-Growth.
- Chris Carosa, “How You Can Profit As Market Shifts From Growth To Value Stocks,” Forbes, October 10, 2019, https://www.forbes.com/sites/chriscarosa/2019/10/10/how-you-can-profit-as-market-shifts-from-growth-to-value-stocks/#44bc3706cb73.