While value stocks have been outperforming growth stocks over the last six years, we would echo Mark Twain that the reports of growth investing's death have been greatly exaggerated. Indeed, we think a number of factors suggest that as an investment style, growth investing could present an attractive set of opportunities for investors in the coming year. The following article looks at some of those factors.

Rumors of growth investing's demise recalls an earlier article my SSgA colleague Arlene Rockefeller wrote in June, 2000, asking “Is Value Investing Dead?”. Arlene was writing at the end of a time of extreme underperformance in value stocks relative to growth stocks since 1998. Her question was prescient, as that point largely marked the peak of the growth stock rally. As Chart 1 illustrates, since that time, the value and growth indexes have traded positions, with value outperforming growth for the last 6+ years, as measured by the Russell 1000® style indexes. Not only has value outperformed growth for an extended period, but the magnitude of this outperformance has eclipsed the growth gains from the late 1990s market bubble. Market participants have predicted a reversal of this trend for some time. Recently, a number of specific drivers; secular, macro and valuation, have converged to suggest that this reversal may be occurring.

Chart 1: Performance of Russell 1000® Growth and Russell 1000® Value Index

Source: Ned Davis Research

Secular Factors
From a secular perspective, the dramatic swings towards growth in the late 1990s and then the sustained outperformance of value over the last six years can be partially explained by extreme performance in traditional growth sectors of telecom, media and technology (the TMT sectors) in the late 1990s and, more recently, the strength of the traditional value sectors, energy and materials. Each of these sectors was a powerful driver for the momentum of the growth and value swings. However, each of these rallies was the result of exuberant earnings expectations which eventually matured closer in line with the overall market. While at present the earnings expectations for the energy and materials sectors do not appear to be at the former “blue sky” levels of the TMT, there is a greater level of maturity analyst estimates, providing less momentum for a continued value rally.

At a macro level, we observe a slowdown in US economic and corporate earnings growth. When growth slows, investors move towards companies that are less sensitive to economic trends or can provide attractive secular growth opportunities.

Valuations suggest that growth is cheap. Within the Russell 1000 Index we note that the growth stocks' price-per-earnings ratio (PE) is now below that of its long-term average relative to the value stocks' PE. While this by itself is not a catalyst for re-rating, it is a necessary pre-condition and supports the larger secular and macro dynamics.

Recent Cycles Extreme
Dividing the investing benchmarks between growth and value characteristics follows from categorizing stocks against a range of valuation criteria such as price-to-earnings ratios and/or price-to-book ratios as well as growth criteria such as forecast earnings growth. The common methods of distinction invariably split the market: value stocks are heavily represented within the financials, energy, consumer staples, utilities and materials sectors; and growth stocks are concentrated in areas such as technology, healthcare and consumer discretionary sectors.

Over the last decade, we have seen extreme swings, first to growth and, after 2000, towards value (Chart 1). While these swings are consistent with the shifting momentum of economic growth, the extent of the swings has also been magnified by particular market and economic events, first in the technology, media and telecom sectors and more recently the commodities markets.

During the final stages of the late 1990s' growth rally, one of the best performing strategies was to buy stocks with negative earnings. This period coincided with the rise of new technologies in the technology, media and telecommunications sectors. Many of these companies had limited profitability, but enthusiastic earnings expectations and had rapidly grown from emerging start-ups to large cap stocks. An eventual maturing in earnings expectations for this group produced a subsequent collapse of growth share prices. In the two years from June 30, 1998, to June 30, 2000, the weight of the technology, media and telecommunications sectors in the S&P 500® Index rose from 24% to 42%. Since that time, the sectors have fallen back to 22% of the Index, as of December 2006.¹

The latest value rally has also been dominated by two significant macro themes. The first has been the strong growth in emerging economies such as India and China and the impact this has had on demand for energy and basic commodities. This has had a significantly positive effect on the energy and materials sectors. The second theme has been the rise in prominence of financial players as holders and traders of physical commodities, which has significantly changed the demand profiles of a range of both hard and soft commodities.

For example, in October 2006 the average value of all positions (long + short + spreads) held by non-commercial commodity traders (investors and speculators) in the US stood at US$125bn.² Citigroup have estimated that non-commercial fund positions add approximately 12% to base metal demand.³ Many investors that have been unable to invest directly in commodities and their derivatives have sought exposure to this trend through equities in the material sectors, pushing up their valuations.

What Historical Relationships Suggest
The relationship between growth and value appears to shift in broad trends, and these shifts can generally be aligned with expectations for economic growth. When economic growth is accelerating, value stocks tend to be in favor, and when economic growth is decelerating, growth stocks with stable earnings tend to be in favor. The underlying explanation of this relationship is simple but powerful. Markets respond to scarcity. When economic growth is slowing, earnings growth becomes scarce. The strength of this action is particularly strong for sectors and stocks that are less sensitive to economic trends or can provide attractive secular growth opportunities. Investors then apply a premium to these stocks.

The Current Macro Backdrop
Present conditions suggest the prospect of a reversal in market conditions from value towards growth may be underway. In terms of the economic cycle, SSgA's economic outlook suggests a slowdown in US GDP growth from 3.3% in 2006 to 2.1% in 2007. This is in line with market consensus data (3.3% and 2.5%, respectively). The implicit forecast of the current yield curve is economic slowing, which has historically indicated a more positive environment for growth stocks. A mid-cycle slowdown in which corporate earnings growth slows and hence becomes less abundant has historically foreshadowed positive results for stocks exhibiting strong and sustainable profit growth.

Viewed from a different perspective, we can see in Chart 2 the corporate profit share of national income since 1950. The chart suggests that this share is close to its historic peak. It does not follow that this trend must reverse in the immediate future; however, the prospect of its continued ascent at its current rate appears unlikely. An environment in which corporate profit share growth is limited again will focus investors towards stocks with solid secular growth characteristics.

Chart 2: US Corporate Profits and Business Investment

Source: FactSet Research Systems, Department of Commerce

Chart 2 also shows US business investment relative to GDP. The most recent peak in investment occurred in 2000, aided by Y2K concerns and the accompanying IT and systems processing orders in the run-up to this potentially critical period. By comparison, investment slumped significantly after this period. The accompanying rise in corporate profit share is related to the subsequent capital spending slowdown. Companies' profit margins were boosted by the consequent drop in depreciation and amortization expense, also accompanied by falling interest expenses over this period. These savings now appear to have leveled out. We anticipate that an acceleration in business investment coupled with rising wage and salary growth will place pressure on overall corporate profits' share of GDP.

The Valuation Gap and the Premium for Growth Stocks
Additionally, growth is inexpensive relative to historical price per earnings levels of growth and value stocks. The valuation extremes reached by the growth stocks during the 1998 – 2000 growth bubble now appear to have been removed. Chart 3 illustrates this point by comparing the price-to-earnings ratio of the Russell 1000 Growth and Value Indexes and the relationship between the two over the past 28 years. Growth stocks have historically traded at a premium of 1.55 relative to value stocks and currently trade at 1.43.

Chart 3: PE Relationship of the Russell 1000 Growth and Value Indexes

Source: Ned Davis Research

Secular Themes
Looking at the underlying sectors also points to the potential for a shift to growth as some of the traditional value sectors such as energy, materials and financials face significant headwinds. The strong rally in energy and commodities prices that helped drive the energy and materials sectors in 2006 appears to at least be leveling out. Oil has retreated over 30 % from its July 2006 high of $77.23. The London Metals Exchange Index (a composite index of six primary metals – copper, aluminum, nickel, lead, tin and zinc) rose 71% from December 2005 to May 2006. Since that time, the index has moved off by approximately 14%. Commodities investors now must review reduced industrial demand expectations and the impact of capital expenditure announcements for production expansion across the sector. Similarly, the financials sector may also face headwinds from the impact of an economic slowdown on credit demand in the housing and consumer markets.

The strength of the value stocks in recent years has been assisted by the emergence of these macro drivers. As we note these themes starting to show some maturity, it also appears that they have also been factored into longer term growth expectations and valuations. As such, it is likely that these themes are unlikely to continue to drive value stocks relative outperformance to the same extent as we have recently seen. At the same time, we see a positive environment for large cap stable growth stocks. This presents a more favorable overall environment for growth stocks.

The SSgA Global Fundamental Approach
SSgA's Global Fundamental investment philosophy is focused on investing in quality companies with identifiable and sustainable competitive advantages. Our research is focused on companies that can demonstrate strong secular growth trends and a quality focus in terms of profits, balance sheet and industry structure. Our investment process is not explicitly based on investing in growth stocks. However, over time, we note that the portfolio characteristics within our strategy has a bias toward a GARP/Growth style. During extreme swings towards value, results will tend to lag the broader market. However, our strategy is aimed to outperform its benchmark during normal periods where modest market movement occurs between growth and value.

¹ Factset, S&P
² US Commodity Futures Trading Commission, October data.
³ Citigroup “Standing by Our Call: Commodity Outlook”, November 18, 2006.

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SSgA may have or may seek investment management or other business relationships with companies discussed in this material or affiliates of those companies, such as their officers, directors and pension plans.

The index performance figures are calculated in U.S. dollars and reported on a gross basis. Fees, including but not limited to the advisory fee, transaction fees and custody charges, would reduce the return. For example, if an annualized gross return of 10% was achieved over a 5-year period and total fees (management, custody, transactional and all other fees applicable to a portfolio) of 1% per year was charged and deducted annually, then the resulting return would be reduced from 61% to 54%. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.

This material is for your private information. The views expressed are the views of Matthew McPhee only through the period ended January 1, 2007 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

Posted On: February 13, 2007