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Has the Growth Stock Rally Left Value Undervalued?

A look at the gap between value and growth through Morningstar Index lenses

Dan Lefkovitz


Even the smartest of betas won't look smart all the time. That’s one of the reasons that Morningstar prefers the term “strategic beta.” Value stocks are a case in point. Academics tell us that investors are compensated for the risk of owning troubled companies with low-priced shares. Companies that under promise and over deliver are believed to win over the long term. 

And yet value stocks have struggled for years now. So far, 2018 is shaping up to be another year of growth dominance. Consider the U.S. Market Barometer, powered by Morningstar® Indexes.  

The five-year view demonstrates the extent of the growth rally. The Morningstar Large Growth Index has beaten the Morningstar Small Value Index by an average of 7 percentage points per year since 2013. Didn't professors Eugene Fama and Kenneth French tell us that value and small-cap value stocks outperform?   

History shows that style leadership is cyclical. The fact that the highest-flying growth stocks are referred to by an acronym—FAANG, for Facebook, Apple, Amazon, Netflix, and Google—is itself a cause for concern. Previous market epochs characterized by growth stock nicknames did not end well. (See TMT—technology, media, and telecom—of the 1990s and the Nifty Fifty of the 1960s.) 

Timing style rotations is a fool's errand. But we can use valuation to predict long-term future returns for the growth and value styles. Won’t value stocks always look cheaper by definition? Not through the lens of a forward-looking gauge of share price relative to the intrinsic value of the business.  

Here, we rely on the work of Morningstar’s equity analysts. When applying their valuation estimates to Morningstar's value and growth indexes, value wins. Today’s U.S. market valuations imply higher future expected returns for value stocks. It's no wonder that the valuation-driven asset allocators at Morningstar Investment Management are shifting from growth to value in the target-date index series they manage.  

Value is Undervalued  

Rolling up analyst-assigned fair value estimates to the index level shows growth trading at a premium to the overall market and value at a discount. Fair value is 1.00.  

It’s also useful to employ the Morningstar Global Risk Model’s valuation factor because Morningstar analysts don’t cover 100% of index weight. The valuation risk factor is derived from the analysts’ work. It relies on an algorithm to extrapolate fair value estimates onto uncovered stocks. It’s a relative not absolute measure. Zero is average for the universe of 45,000 stocks, and higher scores indicate cheaper stocks. The Morningstar Global Risk Model also shows U.S. value stocks as offering better relative value than growth. 

Take a cue from Morningstar target-date indexes  

Timing the market is notoriously difficult. Staying diversified across styles, market-cap ranges, geographies, and stocks, bonds, and other asset classes is sensible. Within the target-date indexes they manage, Morningstar Investment Management is making subtle shifts from growth to value.  

Here’s how they’ve adjusted the allocations of the most aggressive and long-dated vintage of the Morningstar® Lifetime Allocation Index.  

Learn how we used target-date indexes to create the next generation of target-date funds. 

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