The divergence between growth and value stocks is one of the biggest stories of 2018, and equity income investors find themselves on the wrong side of it. Why?

In the first half of 2018, the Russell 1000 Growth Index was up over 7%, and the core Russell 1000 Index was up almost 3%. Meanwhile, the Russell 1000 Value Index lagged with a -1.7% return. Quality equity income stocks tend to be found somewhere between value and core stocks. Growth companies are less likely to pay a dividend because they’re reinvesting in themselves with the goal of growing faster than the overall market, while really deep value companies don’t have cash available to fund a dividend. The result? Quality equity income investors find themselves with returns closer to the core and value indices. And they’re left wondering why.

It’s a growth-at-any-price market

In the current market, growth is winning, and the amount investors pay for growth is less of a concern. One way to look at this dynamic is to understand the underlying factors that have driven equity markets across all sectors and styles. Growth factors have outperformed, and valuation factors have underperformed. This has created a growth-at-any-price market, where valuation doesn’t seem to matter. And expectations for growth matter more.

Growth factors measure a company’s growth trajectory and include price momentum, sales growth and predicted earnings-per-share growth. Valuation factors use financial statements to indicate if a stock is selling at a price that reflects a company’s worth; these types of factors include book-to-price, sales-to-price and earnings-to-price ratios.

No factor is spared — even free-cash-flow yield

The Columbia Threadneedle dividend income team focuses on free-cash-flow yield — it identifies companies that are generating free cash flow and trading cheaply. This means a company can adequately fund its dividend and won’t need to dip into other cash or cut its dividend.

However, free cash flow is currently included in the long list of value-oriented factors that have underperformed on a short-term basis. If you look at the difference in returns between the highest free-cash-low companies and the lowest, you’ll see how this factor has underperformed in the last few months in the current growth market. Valuations don’t seem to matter as much as growth momentum does.

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