Can Value Persist in 2017?

Value stocks had their moment in 2016, outperforming growth stocks by a wide margin, with the S&P 500 Value index up 14.3% compared to the S&P 500 Growth index's 5% return. Value-focused fund categories all boasted double-digit returns last year, with Morningstar's Small Value category notching a near-26% gain.

The question many investors have now is whether value strategies can continue to outperform. Studies have shown that, historically, value stocks outperform growth stocks over time. For instance, Fidelity found that from 1990 to 2015, U.S. large-, mid- and small-value stocks beat U.S. large-, mid- and small-growth between 40 and 187 basis points on an annualized basis, depending on the category. The dominance of one style versus the other, though, often changes from year to year.

What Drove Value Strategies in 2016 Value's revival last year was, for many, long overdue: Between January 2014 and the end of 2015, the S&P's growth stocks were up 18.3% while its value stocks only saw a 4% rise.

Growth's gains during that period can be attributed to falling interest rates and low global economic growth, says Marc Nabi, an investment specialist at Capital Group, which runs

"Many investors believed that growth companies were on sale and they were willing to pay higher than normal price/earnings ratios as long as sustainable growth existed," he says.

It didn't help that two traditionally value-oriented sectors--energy and financials--underperformed the broader index during that period. With oil plunging, the S&P 500 energy subindex fell by 30% over those two years, while the S&P 500 financial subindex fell by 3.5% in 2015.

“Until last year, these two sectors did not participate as much in the U.S. equity market recovery, but they are big drivers of future economic growth,” says Nabi.

With investing, though, what goes down usually comes back up eventually--and both the energy and financial sectors started to climb in 2016. Financials gained 20% in part because of the specter of rising interest rates, which is positive for financial sector stocks. Energy, meanwhile, enjoyed a 23% gain thanks to rising oil prices.

These two sectors also received a boost after the U.S. election, as President Donald Trump's comments on increased infrastructure spending and looser financial regulations pushed these sectors higher.

"In the fourth quarter, investors started to sell those high valued growth companies and take advantage of the low multiple value stocks," says Nabi.

Can Value Climb Further? It's unclear where value might go next, says Russell Kinnel, Morningstar's director of manager research. Stocks are still expensive compared to historical levels, with the S&P 500 now trading at more than 25 times earnings. He thinks the market in general could take a turn for the worse, considering how long the economic recovery has been and how uncertain things are in Washington.

"There's certainly a fair amount of downside for all equities," he says. "It seems like the risks have grown."

Value stocks could still outperform growth equities on the downside, though. It all depends on what drives any market sell-off. Kinnel points out that the 2008 recession hit financials hard, while the 2001 market drop was a result of high technology valuations.

It could be difficult for value to continue performing well because of its outsize performance last year. Value investors tend to invest with the assumption that if you buy something that's cheaper than the market, it will eventually revert to the mean. Now that many undervalued stocks have moved higher, there’s less mean reversion to come.

"Most people would agree that it's tougher to find value stocks today than a year ago," says Kinnel. That has led value managers look more at overseas companies or hold more cash. The ones who must stay fully invested just have to try their best, he says.

Further, the longer-term performance of value versus growth fund categories suggests that value has more than caught up: Value categories outperformed growth categories during the three- and five-year trailing periods ending in 2016, while growth categories maintain a slight edge for the 10-year period.

While it's always hard to predict whether value or growth will outperform in a given year, Nabi says his managers are staying in value stocks--they shifted out of growthier sectors and started buying more energy and financials last year. They think rates will continue climb, while OPEC's deal to cut oil production could help stabilize energy prices. Increased infrastructure spending should also help still depressed energy stocks. Even though prices have climbed, he and his team have no shortage of value ideas.

"All sectors have disconnects between growth and value," he says. "We're long-term investors, so if we have a view, like value stocks are going to perform well, then we keep that view for an extended period of time."

What to Do While a lot of managers are value or growth-only, a diversified investor would be wise to own some of both. Just like you'd want to put your portfolio's assets in different countries or sectors, you might also want to spread your money out among different styles.

"You should be spread out," says Mike Liss, co-manager of

If your portfolio is short on value, though, then you can consider adding value stocks by investing in one of Morningstar medalist funds. Gold-rated large-cap value funds include American Funds American Mutual,

On the mid-cap side, options include the Gold-rated

Because it's so difficult to know what style will outperform, Kinnel also says investors should have a mix of both. Moreover, it is useful to view your portfolio in terms of styles, he says, since, as we saw last year, one style can outperform another.

"It's a useful lens to view your portfolio in," he says. "But look at whether you're leaning too far one way or another, because they do behave differently."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.