In recent years growth stocks have outperformed value stocks. But even with the benefit of hindsight, explanations for this trend may not be particularly illuminating. For example, investors showed a large appetite for biotechnology stocks without much earnings. They also snapped up shares of strong, safe stocks — although finance theory teaches that high prices are followed by low expected returns. Since there is a degree of randomness in these cycles, there’s not much point in obsessing over whether growth stocks will continue to outpace value. Fortunately, long-term investors do not need to divine the future — and are better off holding allocations to both growth and value stocks in their portfolios. A more interesting question is how to construct a growth-stock portfolio that will outperform growth benchmarks over time while controlling for risk.
Looking back in history, a funny thing happened to the value premium — the tendency for value stocks to outperform growth stocks. Value investing pioneer Ben Graham and his star pupil, Warren Buffett, were on to a good thing. Then academics like Gene Fama and Ken French identified and described the value premium in the early 1990s, spurring many quantitative shops to pursue it with strategies such as fundamental indexing. Since Fama and French published their seminal research, the value premium has been whittled down from 5 percent to 1 percent.
Research shows that, compared with active value managers, active growth managers outperform their benchmarks much more frequently — and by significant margins. Decomposing returns reveals that the outperformance of growth managers can almost entirely be explained through excess exposures (relative to the appropriate growth index), or tilts, to risk factors, such as momentum, value and company size. Historically, most quant managers have focused on value stocks, but research demonstrates that quantitative multifactor strategies can also be deployed to improve on the performance of growth indexes.
Of course, any investor can read the abundant academic literature that establishes risk factor premiums (such as for momentum, profitability and R&D) that are applicable to growth investing. The key is not the individual factor strategies; rather, it is how to combine and implement multiple quantitative factors in a portfolio that makes sense from an investor’s point of view. Here are some examples of how to address the challenges.
The momentum factor — the tendency for winning stocks to keep winning and losers to keep losing — is strong evidence against the Efficient Market Hypothesis. The momentum premium is much higher in growth than in value and in small stocks than in large stocks, and it applies to nearly every market around the world. Moreover, unlike the incredibly shrinking value premium, the momentum premium has remained remarkably robust, at 500 to 700 basis points versus the market index. The rub is that momentum is what is called a fast-moving factor. Without rules for controlling portfolio turnover, transaction costs will eat up excess returns from a tilt to momentum stocks.
A way to counter the problem is by combining momentum with value (that is, a tilt to higher book-to-market stocks than the Russell 3000 Growth Index), a slow-moving factor. One of the benefits of blending these two negatively correlated factors in one portfolio is factor diversification. In addition, by combining the value and momentum signals, investors can slow down trading dramatically and improve risk-adjusted performance, both relative to the index and versus the sum of stand-alone value and momentum strategies.
Another challenge in the growth space is small-cap stocks. Most investors know that, whereas returns from small-cap stocks (particularly small-cap value) have historically exceeded those of large caps, the small-cap growth style box has been something of a disaster. But research also reveals that stripping out the stocks with the most growth in this style box dramatically improves the return in small caps. Moreover, many investment factors, including momentum, value and asset growth, work much better in small-company stocks than in large ones. Thus a U.S. growth strategy could target excess exposure to smaller names with more value characteristics when compared with Russell 3000 Growth. There are several more examples. Many growth companies with high stock prices and low costs of capital tend to borrow and invest too much (that is, there is a negative relation between investment and returns). Strategy: Seek negative exposure to the asset-growth factor. R&D, which is expensed, is not captured in the book value of growth companies, but it informs you on future returns. Therefore adopt a tilt toward both high-R&D and more-profitable stocks relative to the benchmark.
In short, by combining multiple quantitative factors in a smart way for better portfolio diversification and by minimizing transaction costs, investors can create a better growth strategy that outperforms benchmarks while controlling carefully for risk.
Gregg Fisher is founder and CIO of New York–based Gerstein Fisher and the portfolio manager of Gerstein Fisher Funds.
