One of the biggest questions captivating investors, seemingly since the beginning of markets, which remains largely unanswered today is the implied dichotomy between growth and value. This topic has loomed over investors throughout every stage in the economic cycle as an additional data point to consider in portfolio construction and despite the application of machine learning and teams of data scientists by large firms the answer is still unclear. This subject continues to maintain relevance in investor circles due to its seemingly obvious hypothetical applications that stem from basic economic principles of “economies of scale”. This thought process boils down to “larger more established firms will be less likely to grow larger due to a lack of incentives but smaller companies have much more potential to grow ”. This line of thinking is then applied to divide companies into “Growth” and “Value” groups depending on a number of factors such as revenue growth and liquidity ratios. The question then becomes, do these two groups’ returns reflect their difference in growth potential?

To answer this question we need to compare the returns of the two categories which are shown in Figure 1. This chart plots the Wilshire 5000 Growth and Value indexes which contain nearly all of the growth and value companies in the US Stock market and tells us that the two groups have highly correlated returns. This means that despite the seemingly simple economic intuition of differing growth potentials translating into differing equity returns is a little more complicated because when one group has high or low returns the other group usually matches. That being said, after performing a linear regression on the two groups’ returns it seems that a 1% increase in growth returns will likely correspond to a roughly 0.77% increase in value returns. This result seems to fit much better with the intuition applied earlier because despite highly correlated returns growth has a slightly elevated return potential. So if this relationship is so intuitive and the return differences are so easily calculated why would anyone ever invest in value?

Shown in Figure 2 are the overlaid return distributions of both groups and although they may appear to be almost identical there are some subtle differences. The value group appears to have a slightly higher concentration around zero whereas growth appears to be slightly wider. While this may not seem like a meaningful difference, growth actually has about a 16% wider distribution in returns compared to value meaning that although growth is likely to have a higher return over a long period of time it is also likely to be more volatile during that period. This difference in distributions makes sense because investments with higher returns usually correspond with increased risk. So despite growth posting higher returns on average it also contains a higher risk profile.

This increased risk profile stems from the types of companies contained in the growth category which can be seen in Figure 3 which plots the sector weights of both groups and the entirety of the Wilshire 5000. This figure tells us that the two largest growth categories are Digital Information and Technology while the two largest value categories are Financials and Health Care, which are some of the highest and lowest risk profiles historically respectively. This means that the returns and volatility differences observed between these two groups can be explained by the very differences in their constituents which shape their respective historical tendencies. Given their sector differences one might try to construct more robust portfolios, meaning portfolios that can change with market conditions. This is where the seemingly simple economic principles hold their weight.

The thought process goes something like this “The economy is slowing and individual incomes are lower, so people will spend less on unnecessary things and more on necessities therefore value is the portfolio for me”. A similar line of thinking can be applied to the current inflation surge, specifically the effect that large price increases have on consumer spending and market returns. Shown in Figure 4 is the average annualized returns for all sectors since 1980 grouped by annualized inflation. This figure is rather dense but has a lot of meaningful information within it. One important point is that growth outperforms value in nearly every situation except moderately high inflation, which falls between 5 and 10%, which also happens to be where the vast majority of recent inflation estimates have lingered. Another fairly obvious detail is that most sectors do not do well in very high inflation, which lies above 10%, which makes sense given the severity of an inflation estimate of that caliber. Another subtle but somewhat important detail lies in the moderate inflation, which falls between 0 and 5%, which contains the highest return profiles of any inflation group. These high returns are representative of the sweet spot in the economy, typically pre-recession and post-expansion, and therefore correspond with the highest returns of most sectors.

Although the relationship between growth and value is not as clear-cut and intuitive as the foundational economic principles that inspire them, as we have seen there does exist some tendencies and associations driving their respective market returns. That being said, the differences in risk and returns between the two and how these differences can be used to follow market conditions are important considerations in investing and portfolio construction. These considerations have driven large financial firms to pour high amounts of time and money to determine the same result of the simple analysis above. With all of this in mind perhaps a binary system is not the best way to represent companies with differing growth potentials and it might be more feasible to have more groups seeing as portfolios are no longer constructed by hand. The application of technology and machine learning to finance means that the simple models created decades prior are becoming obsolete and as markets progress the debate of growth and value may be replaced entirely begging the question, did we get it right the first time?