Growth vs Value: An Age-Old Debate
Using 13F filings, we measure whether hedge funds prefer growth stocks or value stocks, and which has historically proved the better investment strategy.
A few months back, global asset management firm AB Bernstein announced that value investing has become "increasingly irrelevant." They cite central bank quantitative easing and the expansion of information technology. This was countered no less than a day later by Goldman Sachs, rebutting that wide valuation gaps between expensive and cheap stocks have historically foreshadowed strong performance for value names.
Such claims by prominent institutions are often catalysts; creating ripples in the market, maneuvering expectations, and triggering hedge fund activity. But this debate is not new, either. This article examines how hedge funds have responded to the growth vs. value debate, and whether managers have a preference for one or the other. In our analysis, we will be considering the Novus Hedge Fund Universe (HFU), a proprietary portfolio that aggregates data from over 1500 underlying managers.
The Quick Definitions
A value stock is a security that is perceived to be undervalued, and therefore trades at a lower price than what the company’s true performance may indicate. Value investing, a concept popularized by some of the most famous investors of our time such as Warren Buffett and Benjamin Graham, is simply the act of picking stocks that appear to be trading for less than their book value.
A growth stock, on the other hand, is a security issued by a company that is anticipated to grow at a rate significantly above the average for the market. Growth stocks tend to belong to sectors like information technology, biotechnology or consumer discretionary services. As opposed to value stocks, growth stocks are usually overvalued, since investors expect these stocks to earn capital gains over time.
Isolating Value Performance from a Factor Model
Our last post explored at length how investors can use factors for effective portfolio management. Many investors use the Novus platform to analyze portfolio risk by isolating the effect of various factors on security returns. This builds on existing academic literature, most notably the Fama French Three Factor model, a 1992 asset pricing model that extended the traditional capital asset pricing model (CAPM) by analyzing the contribution of size and value factors (in addition to the market factor) on security returns.
Factor model visualizations look like this:
Now, the factor relevant to this article is the value factor—the red line in Figure 1—and it accounts for the spread in returns between value and growth stocks. The factor itself is constructed by taking a portfolio of stocks with a high book-to-market ratio (Value Stocks) and subtracting from it a portfolio of stocks with a low book-to-market ratio (Growth Stocks).
Using the constituents of the Russell 3000, we can simulate the performance of this factor over time. Given the long-standing nature of this debate, we’ll take a 10-year lookback window for our analysis. Let's now isolate Value R3K from the US Factor Model:
We can see that the value factor (interpreted more intuitively as value minus growth) is declining over time. This indicates that, based on the portfolios of stocks in the Russell 3000, growth stocks are outperforming value stocks over time.
Does this put the age-old debate to rest? Not quite. What performance fails to capture is the higher risk associated with growth stocks. As we also know, due to the lack of dividends paid out by growth stocks, the only opportunity an investor has to earn money on their investment is when they eventually sell their shares. If the company performs poorly, investors take a loss on the stock when it's time to sell. While this may be enough to cause risk-averse investors to shy away from these stocks, it is interesting to see whether those in the industry who rely on their risk appetite to generate returns are actively tapping into the potential growth stocks seem to offer.
Hedge Fund Preferences
Using public filings of all the underlying managers in our tracked universe, let's now isolate the aggregate portfolio’s exposure to the value factor:
This chart appears to be significantly more volatile in our 10 year lookback window, although exposure to the factor has remained largely negative since 2009. Since the portfolio is constructed from long positions only, we can interpret the negative exposure as a preference for going long on more growth stocks than value stocks.
Contribution to the Portfolio
Now time for some basic arithmetic. Contribution is equal to performance multiplied by exposure. Therefore, in the case of this factor, contribution is derived as follows.
Contribution = (performance of value stocks – performance of growth stocks) x (exposure to value stocks – exposure to growth stocks)
Given a multiplication problem with two negative numbers as inputs, we'd expect the outcome to be positive:
What this graph tells us is that the Hedge Fund Universe's preference for growth stocks and the subsequent performance of those growth stocks has benefitted their portfolios, or contributed positively.
Based on what we see among hedge funds, the case for growth stocks outperforming value stocks over the last decade is indeed a strong one. Hedge funds seemed to have indicated their stance on the debate by betting big on growth stocks, resulting in a negative exposure to the value factor, and thus a positive contribution from the factor on the aggregate portfolio.