Vanguard’s Joe Davis: ‘Value Stocks Are Likely to Outperform Growth’

In the decade through December 2020, Vanguard Growth ETF VUG generated nearly double the return of its value counterpart Vanguard Value ETF VTV. But in a recent interview on Morningstar’s The Long View podcast, Vanguard’s global chief economist Joe Davis said that he expected value stocks to make up for lost time. He also expounded on the thesis that low-quality growth stocks are significantly overvalued, which he discussed in a recent paper about asset bubbles. The following is an excerpt from the conversation; it has been lightly edited for clarity.

Jeffrey Ptak: You single out low-quality U.S. growth stocks as appearing frothy today. How do you define low quality in this case?

Joe Davis: Well, I think that's just the combination of really very little, if any, earnings, which tends to happen in younger companies or in certain fields such as technology. [These are] companies that tend to be ranked lower on the value spectrum, that is, more growth companies, so high price/earnings, if they have earnings at all. And then, secondly, the lower quality of the earnings. So, effectively, the E is even lower in that equation or negative. Historically, those companies that have these characteristics have underperformed the broad market, which is why you hear some talk about factor risk premiums, such as value-type stocks. But that certainly has reversed and has not been the case over the past decade. In fact, growth companies' outperformance has been eye-opening and nearly unprecedented over the past 10 years. And then, the question is that recent trend: Does it reverse, or is it this time different? We believe it will ultimately reverse given the things that we can get into.

Christine Benz: One question that has come up a lot recently is whether this period is analogous to the late 1990s, the dot-com-bubble period. What do you think are the major similarities? And what do you see as the key differences?

Davis: I think there are certainly two similarities. One is, and actually, if you even go beyond just the late 1990s, any time in human history, financial market history, where there's been a bubble, there are at least two characteristics, which I think are in place today, and it's questionable on the third. One is, there's a compelling narrative that this time is different. And so, typically, there's a new type of asset or type of company whose value has really risen dramatically. It's everything from the South Sea to different stocks in the late 1990s, obviously, tied to the Internet. Today, it's new forms of technology. Nevertheless, it has the same sort of characteristics that these sorts of companies or industries are going to "change the world." And some of that may clearly be true. I mean, some companies emerged out of the 1990s that ultimately changed retail. Amazon AMZN is a good example.

And then, the second one really is too significant of a discounting of future growth. So, that's where I think there's a deviation between the growth prospects for these industries and companies and what will realistically be delivered, even if their growth is still substantial in the future. So, for an example, some companies, their valuation or their price today effectively assumes that they own if not the entire part of their market in their business at least a high percentage of that. So, effectively, what happens in bubbles is that I think one of the underpinnings for its ultimate deceleration in price is that they underestimate either regulatory change, or I think more likely going forward, new entrants, which actually compete on market share. And it's the very capital and the price appreciation and technology and innovation that actually increases other future market competitors. And so, I think that, at times, investors have tended to underestimate that point and instead have really become fascinated with the growth prospects. And I think that is the environment we're in now for some companies--not all, and it's not very broad-based--but it's certainly in parts of the U.S. and global equity market.

Ptak: Do you think the recent rally in value stocks compared to growth has addressed this issue somewhat? Or is there still ways to go on the growth-versus-value imbalance?

Davis: Well, if you give us several years to look out, because I think that's important, because no one and certainly not us will get the timing right. There are elevated odds that ultimately the underperformance of value, not all of that, but a portion of that will be unraveled. So, value stocks are likely to outperform growth stocks in the future. Now, part of that reason is the macro fundamentals. If you believe the market, if you believe the consensus scenario over the next several years, there should be an improvement in growth and modest rise in real interest rates. That's important because the macro fundamentals have explained roughly two thirds of the value stock universe's underperformance over the past decade. It just didn't happen by accident. Some of this was well justified.

Something else happened roughly six months ago. And so, in addition to macro fundamentals potentially being a tailwind, that is, a global recovery, for value stocks, the second one is much more of just the increased overvaluation of growth even relative to those fundamentals. And even when we give growth companies the benefit of the doubt of what we call technological change, so R&D expenditures, changes in platforms, greater investment and demand for those type of services, even when we credit that as an asset rather than an expense, which is typically done in accounting, they are still overvalued in our framework. And that only happened very recently. So, this wasn’t the fact that at least to us growth stocks have been overvalued for several years. It’s actually a much more recent phenomenon. And when that has happened, again, at least historically, with the benefit of hindsight, there’s generally been a reversion to the mean and a modest underperformance of whatever asset that’s significantly above those fair value metrics. So, I think it’s that second point in addition to the first that give us higher-than-average likelihood that over the next several years the value premium will be realized for investors, which actually would be good news because as you know--and Morningstar has documented--value stocks have been a significant underperformer in a globally balanced portfolio for at least a decade.