Should you be a value hound or a growth investor?
The partitioning of equities into growth or value styles has its strongest foundations in Eugene Fama and Kenneth French’s work on the value effect--the tendency for stocks cheap by fundamental valuation measures to outperform stocks expensive by the same measures. Before you dump your clients’ growth holdings, consider why this may be the case. Fama, French, and many other very smart people think value’s outperformance wholly sensible. Value stocks tend to do horribly during recessions; growth stocks fare relatively well. It’s with this fact in mind that we decide how to allocate to growth and value.
1 Assess the true portfolio
Your client’s portfolio isn’t just stocks, bonds, and cash. It’s his or her job, human capital, house, pension, and everything else that generates income. An easy way to estimate an income stream’s value is to see how much it would cost to replicate it with an annuity. If the client has lots of safe assets, consider holding more value stocks. If not, more growth.
2 Consider bear-market sensitivity
If clients work in a highly cyclical industry, consider easing up on value stocks and shading toward growth stocks. A bear market increases the probability their employer will cut their pay or even fire them. The increased probability of such events means their human capital is less valuable than it otherwise would have been.
If their job is insulated from market behavior or better yet anticyclical, consider loading up on value stocks. They effectively act as an insurer to investors who can’t or don’t want to hold recession-sensitive stocks. Therefore, they should expect higher returns.
3 Assess options
The major large-cap value and growth indexes are almost identical in behavior. The index families distinguish themselves in their small- and mid-cap style indexes. As a good rule of thumb, the more small-cap- and value-laden a fund, the greater its recession sensitivity. Another point of caution: Dividend strategies can vary quite a bit in their recession sensitivity. High-yield and yield-weighted strategies tend to decline much more in bear markets than dividend-weighted strategies do.
Not Just for Efficient-Market Types
We don’t think value strategies outperform only because they’re more sensitive to recession risk. Human nature has a strong hand in bidding up growth stocks. But even though value stocks may be consistently underpriced, they’re undeniably more sensitive to recession risk. All investors should consider this fact when pondering their portfolio allocations.