May 13, 2021 | Vanguard Perspective

Our outlook for value? Brighter days ahead!

Over the last 10 years, U.S. growth stocks outperformed U.S. value stocks by an average of 7.8% per year.1 Powered by a relentless rise in technology share prices, growth stocks have handily outpaced value since the 2008 global financial crisis. Simply put, growth has historically never outperformed value as it has over this past decade.

Are we seeing a reversal of fortune with the value premium asserting itself once again? Will your clients' asset allocation strategies be positioned to take advantage of this shift?

Vanguard's latest research suggests that there is a fundamental explanation for some of value stocks' recent woes, such as the inflation and growth environment, but that the narrative has been oversold. Based on our fair-value model, we expect value to outperform growth over the next 10-year period by as much as 5% to 7% per year and perhaps by even more over the next five years.

The unprecedented recent outperformance of growth over value

The chart shows the 10-year annualized return of a portfolio that is long value and short growth. The line is above zero, hovering around 5% from 1936 through 2010, except for a brief dip in the beginning of 2000. For the last decade, however, the line is significantly below zero, reaching a low point of negative 6% in August 2020, demonstrating the unprecedented underperformance of value relative to growth.

Source: Fama-French research returns, outlined at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html#Research.

Notes: The chart displays annualized 10-year trailing returns of a long-short value versus growth portfolio over the period from June 1936 to January 2021 constructed using Fama-French methodology, available at https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/f-f_5_factors_2x3.html. Past performance is no guarantee of future returns.

1 Value and growth are represented by a market-capitalization-weighted index of companies in the bottom and top thirds of the Russell 1000 Index, sorted by price/book ratios and reconstituted monthly. Data are as of February 28, 2021.

Secular trends are driving fair values, but the market may have overreacted

Our model suggests that value stocks’ underperformance in recent years owes mainly to fundamental drivers, notably, low inflation rates, which boosted the relative attractiveness of growth stocks' more distant cash flows. But investor behavior played a role as well.

The model highlights some key points about our fair-value estimates:

  • The decline in the fair value of value/growth has more to do with a large increase in the fair value of growth/market than with a large decrease in that of value/market.
  • Value stocks are much more sensitive to cyclical drivers such as market volatility and corporate profits than are growth stocks.
  • Growth and value appear to be at the upper and lower bounds of their respective fair value to market estimates.

Value stock price/book ratio divided by growth stock price/book ratio

This is a line chart with four lines. One line represents the actual value of the value to growth price to book ratio, the second line represents the estimated fair value of the value to growth price to book  ratio, and two more lines represent the error bands (one standard deviation above and one standard deviation below fair value). The value to growth ratio stays within the fair-value range for almost the entire period, except for going above it in 1993‒1994 and below it during the dot.com bubble of 2000. The ratio then goes below the fair-value range again in the past year, reaching its lowest point in August 2020, and then moves back up slightly (but is still below fair value) over the past few months.

Sources: Vanguard calculations, based on data from FactSet, U.S. Bureau of Labor Statistics, Federal Reserve Board, Thomson Reuters, and Global Financial Data.

Note: The statistical model specification is a seven-variable vector error correction (VEC) that includes the following variables: prior-period ratio of price/book, 10-year trailing inflation, 10-year real U.S. Treasury yield, equity volatility, growth of corporate profits, and ratio of R&D expense/book value estimated over the period from January 1979 to February 2021.

Value signaling a resurgence

We believe that cyclical value-growth rotations are rooted in investor behavior and that investors become more price-conscious when profit growth is strong. Since 2008, corporate profit growth has been insufficient to sustain value stocks.

As inflation normalizes, we expect it to eventually exceed the Federal Reserve's target. Improved performance from the energy, materials, and financial sectors may be signaling a resurgence in these beaten-down value-oriented segments. However, the ultimate driver of the predicted rotation to value stocks is apt to be a change in investors' appetite for risk.

Our research found that deviations from fair value and future relative returns share an inverse and statistically significant relationship over the next 5- and 10-year periods. The relationship is an affirmation that, ultimately, valuations matter—that the price we pay influences our return.

The drivers of value outperformance over the next 5- and 10-year periods

Panel a is a box-and-whisker plot of the 5-year and 10-year annualized distribution of the total return of value relative to growth (which is a sum of the return from the change in fair value and the return from reversion to fair value).  
Panel b is a box-and-whisker plot of the 5-year and 10-year annualized distribution of total return owing to the change in fair value of value relative to growth. 
Panel c is a box-and-whisker plot of the 5-year and 10-year annualized distribution of total return towing to the reversion to fair value of value relative to growth.

Sources: Vanguard calculations, based on data from FactSet.

Notes: Returns are calculated based on a modeled reversion to fair value and a projection of the fair-value ratio of value/growth price/book. Total return in panel c is the sum of the return components in panels a and b at each percentile. Note that numbers may differ slightly because of rounding.

Eventually, we believe that value will take the lead again, as it did through most of the first decade of this millennium. For investors with sufficient risk tolerance, time horizons, and patience, an overweight to value stocks could help offset the lower broad-market returns we expect over the next decade.

View our lineup of low-cost value Vanguard ETFs®

CRSP ETFs

Mega Cap Value MGV 0.07%
Value ETF VTV 0.04%
Mid-Cap Value  VOE 0.07%
Small-Cap Value  VBR  0.07%

Russell ETFs

Russell 1000 Value VONV  0.08%
Russell 2000 Value VTWV  0.15%

S&P ETFs

S&P 500 Value  VOOV  0.10%
S&P Mid-Cap 400 Value IVOV 0.15%
S&P Small-Cap 600 Value VIOV  0.15%

Factor ETF

U.S. Value Factor VFVA  0.14%

Notes:

  • For more information about Vanguard funds or Vanguard ETFs, obtain a prospectus (or a summary prospectus, if available) or call 800-523-1036 to request one. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
  • Vanguard ETF Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • All investing is subject to risk, including the possible loss of the money you invest.
  • Past performance does not guarantee future results.
  • There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
  • In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.
  • Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks.
  • The Factor Funds are subject to investment style risk, which is the chance that returns from the types of stocks in which a Factor Fund invests will trail returns from U.S. stock markets. The Factor Funds are also subject to manager risk, which is the chance that poor security selection will cause a Factor Fund to underperform its relevant benchmark or other funds with a similar investment objective, and sector risk, which is the chance that significant problems will affect a particular sector in which a Factor Fund invests, or that returns from that sector will trail returns from the overall stock market.