The opposite of Value is not Growth

May 15, 2019

Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance. Growth is simply a component -- usually a plus, sometimes a minus -- in the value equation. - Berkshire Hathaway’s shareholder letter in 2000

Nothing like setting the tone with a quote from Warren Buffett. While expectations of future growth affect a stock’s intrinsic value, Value and Growth do not exist on a single, continuous spectrum and are not diametrically opposite to each other.

Holly Framsted penned an interesting post on why Growth and Value aren’t the only options, and Quality can help position portfolios for the economic cycle. She is the Head of US Factor ETFs, within BlackRock's ETF and Index Investments Group. 

The market experiences a gradient of cycles, extending beyond recoveries and expansions to include slowdowns and contractions.

So investors ask the wrong question when they weigh if it is time to sell traditional growth and rotate into value.  Rather, in an environment where many Growth-oriented stocks may be priced to perfection, and clients are looking to make portfolio changes, is Value necessarily the right place to turn?  If your projections support an environment of economic recovery, then the answer might well be yes. If however, you believe markets are heading toward a slowdown or contraction, Value may not be the most timely investment strategy to deploy.  In this latter case, seeking more resilience may be warranted.

While the popularity of Value and Growth is undeniable, the issue with the binary choice between Value and Growth is that, in the most general sense, both are foundationally risk-on approaches. Quality investments can offer a protective middle ground between the typical Value and Growth dynamic. Quality companies generally exhibit more profitability, less leverage and stable earnings relative to their peers, making them more resilient when earnings may have peaked or an economic cycle is maturing.

Andrew Ang, who leads BlackRock’s Factor-Based Strategies Group, explains the difference between Value and Quality. 

  • Value 

The intuition is that securities priced at a discount to their fundamental value have historically outperformed those priced at a premium. It’s worked due to rewarded risk (traditional manufacturers are less flexible than firms that can pivot) and investor bias (staid value stocks are overlooked by investors dazzled by growth). The value factor may perform best when the economy is in recovery mode and growth is accelerating from a trough.

  • Momentum

The intuition is simple: prices moving upward tend to continue moving in that direction. It’s worked due to rewarded risk (when price trends reverse, the crash may be big) and investor bias (investor behavior tends to exacerbate existing trends). Momentum may perform best during expansion mode, when growth is accelerating and trends persist.

  • Quality

The intuition is that financially healthy companies tend to outperform less-efficient peers. Quality has worked due to investor bias: superficial investors are attracted by high headline earnings, while diligent contrarians investigate the underlying composition. Quality may perform best during slowdown and contraction  phases when growth is decelerating and investors seek safety. 

  • Size

The intuition is that smaller, nimbler companies tend to outperform larger ones. The size factor has worked due to rewarded risk because smaller companies are less liquid and more sensitive to market movements. Similar to the value factor, the size factor may perform best during a recovery. 

  • Minimum volatility

Unlike the previous four style factors, which are primarily used by investors seeking to enhance portfolio returns, this seeks to reduce portfolio risk. The intuition is that securities with prices that move around less can deliver returns similar to the market with less risk. The factor has worked due to structural impediment, because some pensions and endowments have restrictions against leverage, driving them toward high-risk stocks to meet high return targets. There is also investor bias when low-risk stocks are overlooked by investors flocking to the next big idea. Minimum volatility, much like quality, may perform best during slowdown and contraction phases when growth is decelerating.

At the Morningstar Investment Conference in Chicago, Holly Framsted conversed with Ben Johnson, Morningstar’s director of global ETF research. Here are the excerpts from the conversation.

When value strategies work best

Value tends to work best coming out of an economic trough. So as the economy expands, these companies with greater operating leverage tend to capture that upswing in the economy far more effectively. As the economy heads toward more stable and steady prolonged growth, then Value tends to take a backstage to Momentum. And as we head toward a slowdown and a contraction, more-defensive strategies like Quality and Minimum Volatility tend to shine.

Current U.S. market

We've been in a prolonged period of economic growth, particularly a time which tends to favour momentum. And that economic growth has been sustained and even extended in many ways through quantitative easing. We believe that we're in now a period of slowdown which should by normal cyclical standards head toward a contraction at some point. So while value has not been favoured in the most recent regime, we do believe it will come back as the economy rebounds off the low.

Understand the economic intuition behind why you are investing in a strategy

Value companies tend to have a lot of operating leverage, and the cyclicality in their performance is a risk that not all investors are willing to bear. Unless you expect that all investors will suddenly be able to bear a prolonged drawdown--which arguably they can't --then you would expect that value premium to persist moving forward. Because not all companies will all of a sudden become flexible enough to be worth a premium over time.

I also think it's important not to throw the baby out with the bath water. Value has been underperforming, but all factors are cyclical. A portfolio that balances across factor exposures including value, but also including quality and momentum as examples, can help deliver more consistent performance throughout the course of the cycle.

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Rajshakher Kanna
May 22 2019 09:54 PM
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