How Much Worse Can It Get for Growth Stocks?

As the dust settles on a brutal second quarter, investors in formerly high-flying growth company stocks are facing their largest losses since the financial crisis. When compared with value stocks, it was growth’s worst performance since the wake of the dot.com bubble collapse.

For investors, while the plunge in growth stocks has left many names at the cheapest valuations in years, the outlook may still warrant a careful stance and long-term horizon.

The Morningstar US Growth Index lost 25.3% in the three months ended June 30, making for its worst quarter since the financial crisis in 2008 when it lost 28.4%. Amazon AMZN and Tesla TSLA, two of the market's best performers in recent years, plunged 34.8% and 37.5%, respectively.

That’s just one of many “worst since” stats for growth-stock investors to swallow.

• The Morningstar Large Growth Index's 29.8% loss for the quarter was the worst since the fourth quarter of 2000, the most in almost 22 years.

• When compared with value stocks, growth lagged the most since the third quarter of 2001. In the most recent quarter, the Morningstar US Value Index topped its growth index counterpart by 15.9 percentage points.

• Large value beat large growth by 21.6 percentage points, the biggest gap between the two since the fourth quarter of 2000 when value beat growth by nearly 32 percentage points.

• Through mid-year, value is ahead of growth by 26.9 percentage points. That's the most for the first half of a year in the history of the index, which dates back to 1997.

• Large value has outperformed large growth by 32.7 percentage points so far in 2022. That is the widest gap between the two since the second half of 2000, when value topped growth by 49.5 percentage points.

Of course, with the broad stock market in official “bear” territory with losses of more than 20% from their most recent peak, even value stocks provided only limited shelter from the storm. As a group, value companies fell 9.4% for the second quarter as measured by the Morningstar US Value Index. From January through June, the Morningstar US Value Index is down 7.3% while the Morningstar US Growth Index plummeted 34.3%.

The collapse of growth stocks marks the dissolution of a long-standing trend. The Morningstar US Growth Index has beaten the Morningstar US Value Index for the last five years, and in nine of the past 10 years. The last time value outperformed growth on a calendar-year basis was in 2016.

Though value stocks are taking the lead versus growth for this year, growth stocks are still on top over the long term. For example, the Morningstar US Growth Index returned 12.7% per year on average over the past five years, compared with 7.8% for value.

And over an even longer-term basis, growth remains far ahead of value. For the past 10 years, growth stocks are up 258.5% while value stocks rose 174.9%.

“It’s been a tremendous reversal, and it caught some investors by surprise,” says Marta Norton, chief investment officer for the Americas at Morningstar. “But we think there’s room for value stocks to continue to run, given the amount of overvaluation that was baked into some of these growth areas.”

Why Are Value Stocks Outperforming Growth?

Coming into 2022, many growth stocks—especially technology names—were trading at lofty valuations thanks to their perception as a haven during the pandemic-sparked recession. Those high valuations left them vulnerable to any significant changes in outlook for the economy.

The narratives of rising rates, economic growth, inflation, and a possible recession have been dominant factors, Norton says, largely favoring most value-leaning sectors versus growth.

“There are multiple factors at play,” Norton says. “But many of the current performance drivers have been friendlier to value stocks.”

Understanding the difference in performance between value and growth stocks starts with their definitions.

Morningstar assigns each stock a “style score.” These scores are relative, with companies landing in the value, core, and growth Morningstar categories.

The style score is based on metrics such as growth rates for earnings, sales, book value, and cash flow. It also factors in dividend yields and relative valuations such as the price/projected earnings ratio, price/book, price/sales, and price/cash flow.

Growth stocks have higher readings on earnings and sales ratios, for example, and low dividend yields. Companies that score at the lower end of the spectrum are in the value category, and those in the middle are considered “core.”

Central to growth’s stocks performance in 2022 has been their valuations, which are largely based on expectations for earnings in the future. And those criteria are affected by the level of interest rates.

As Morningstar strategist David Sekera noted, when rates are low, the value the market places on those hefty future earnings is high. But as interest rates rise, as they have this year, the relative value of those future earnings diminishes the present worth of those stocks as well. In addition, amid concerns about a slowing economy, investors have also ratcheted back their expectations for earnings growth.

Factors affecting the dynamics of the market including the war in Ukraine, supply chain disruptions, and global inflation.

“These have propelled the energy sector to perform the way it has,” Morningstar’s Norton says. Other value-leaning sectors including consumer defensive and basic materials have fared better than fast-growing tech sector companies since “they are seen as areas of safety,” Norton says.

A handful of high-profile growth stocks were responsible for much of the nearly 30% decline in large growth during the second quarter thanks to their heavy weights in the index. The biggest contributors to the fall were Meta Platforms META down 27.5%, Amazon AMZN, off 34.8%, and Snap SNAP, which plummeted 63.5%. All three are now trading at five-star, undervalued prices, according to Morningstar's stock analysts, and several more have reached price levels at four-star discounts compared to their fair value estimates.

Small-cap growth stocks also took heavy losses. The

Index ended the quarter down 22.4%, its largest quarterly drop since 2008.

The index was dragged lower by stocks concentrated in the technology, healthcare, and consumer cyclical sectors. Cloud and mobile services company MicroStrategy MSTR tumbled 66.2% for the second quarter, and fintech banking company Silvergate Capital SI fell 64.5%.

For now, more turbulence is likely ahead, and macroeconomic factors are bigger swing forces than they have been previously, Norton says.

“Expensive growth companies have started to selloff to much more attractive levels,’’ Norton says. “Now that they’re at better valuations, they are more appealing to many investors. But that doesn’t mean they will rally again any time soon.”

“Valuations and prices aren’t timing indicators, but they do matter,” Norton says.

Will Value Keep Outperforming?

Growth stocks outperformed for the better part of a decade. That makes the recent resurgence of value stocks look nascent by comparison.

Morningstar analysts now see more than half of the companies that they track in the Morningstar US Value Index, 145 out of 268, as undervalued. A few companies that had strong runs in the second quarter, including AT&T T, Cigna CI, and Gilead Sciences GILD are still trading well below their fair value estimates.

In the wake of the selloff, growth stocks are, on balance, significantly undervalued based on Morningstar fair value estimates. But Norton says investors should still be selective.

“The former imbalance of growth outperforming value had built up for a long time,” Norton says. “It’s hard to say that we are at a neutral point.”