Which performed better in recent years, growth stocks or value stocks? Differentiating between these characteristics is a popular way to segment the US stock market (next to segmentation by market capitalization). Value stocks can be roughly described as "bargains". These stocks are usually associated with low P/E, low P/B, low price/cash flow, and a high dividend yield. These companies may have solid fundamentals, but their stock prices are perceived to be lower than their intrinsic value due to factors such as market conditions, industry trends, or temporary setbacks. Value stocks are often associated with more mature industries or companies that are temporarily out of favor with investors. Growth stocks are the exact opposite. They are considered expensive measured by a variety of metrics. These stocks generally do not pay dividends, as the companies usually want to reinvest any earnings in order to keep growing at certain rates. These companies often operate in industries that are expanding rapidly or are engaged in innovative technologies. Investors are attracted to growth stocks because of their potential for significant capital appreciation over time. Examples of growth stocks can include technology companies, biotech firms, or high-growth consumer brands.
Value and growth investing are opposing strategies. A stock prized by a value investor might be considered worthless by a growth investor and vice versa. Value investors seek to profit as the price returns to its “fair value" while growth investors are looking for "winners" and focus on competitive advantages.
The ratio in the chart above divides the Wilshire US Large-Cap Growth Index by the Wilshire US Large-Cap Value Index. When the ratio rises, growth stocks outperform value stocks - and when it falls, value stocks outperform growth stocks. The ratio peaked in 2000, during the dot-com mania.
The Wilshire Large-Cap includes the top 750 ranked components of the Wilshire 5000 index measured by market capitalization.
The Wilshire Mid-Cap includes the components between 500 and 1000 measured by market capitalization. Therefore it's considered a benchmark for mid-cap stocks.
The Wilshire Small-Cap includes the components between 750 and 2500 measured by market capitalization.
Wilshire further divides these indices into growth and value, which are defined by looking at six factors: projected price-to-earnings ratio, projected earnings growth, price-to-book ratio, dividend yield, trailing revenue growth and trailing earnings growth. All indices are capitalization-weighted and they are total return indices, which include reinvested dividends.
The chart above displays the 1-year rolling correlation coefficient between the Wilshire US Large-Cap Growth Index and the Wilshire US Large-Cap Value Index. A correlation coefficient of +1 indicates a perfect positive correlation, meaning that the two indices moved in the same direction during the specified time window. Conversely, a correlation coefficient of -1 indicates that they moved in opposite directions. The chart shows that the correlation between growth and value equities is mostly positive and appears to dip only around economic recessions. The correlation coefficient is important for diversification because it helps investors assess the potential benefits of including both growth and value equities in their investment portfolios.
Diversification is the practice of spreading investments across different asset classes to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
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