It is commonly assumed that growth stocks are bigger beneficiaries of falling interest rates than value stocks, an assumption driven by a belief that growth stocks are much longer “duration” than value stocks due to the fact that more value in growth companies comes from relatively more distant cash flows. While it is true that value stocks do generally offer higher current income than growth stocks, a focus on this aspect gives a false idea of how returns are generated in both investing styles. A more comprehensive analysis of the drivers of return for the value and growth styles of investing shows that their durations are much closer than most investors realize. Given the wide discount at which value stocks are currently trading globally, we expect value to continue to outperform the market over the next few years, but that belief neither assumes nor requires any particular moves in interest rates.
Over the last few weeks, we have seen a rise in bond yields alongside an outperformance in global value stocks relative to growth stocks. While we at GMO have certainly been happy to see some recovery in value stocks (and we are confident that this recovery has much further to run), the moves have only reinforced a narrative that has been gaining ground in recent years – that value stocks are a “shorter duration” asset than growth stocks and should naturally outperform whenever interest rates are rising and underperform when they fall. This narrative is a tempting one, as it both matches with the pattern of performance for value and growth stocks in recent years and comports with a simple model of how returns are generated. However, the narrative is flawed because the simple model of value and growth stocks that it portrays is too simple and is missing a key driver of returns. Neither value nor growth indices hold a constant set of securities through time, and this inherent turnover (“rebalancing”) has profound effects on the returns they deliver over time. This turnover pulls the effective duration of value and growth stocks quite close together. It also explains why, in the long run, growth stocks wind up generating much lower returns than the combination of their growth and income imply. The prevalence of the duration narrative in the financial world and the fact that value stocks are probably somewhat more cyclical than growth stocks at the moment mean that the correlation between value stocks and bond yields may well continue for some time to come. But as it turns out, there is little truth to the argument that a value-driven equity portfolio is a materially shorter duration investment than a growth-driven one. Given the wide discount at which value stocks are currently trading globally, we expect value to continue to outperform the market over the next few years, but that belief neither assumes nor requires any particular moves in interest rates.
The Correlation Between Bond Yields and Value
It is not an illusion that the performance of value versus growth has been correlated with bond yield moves in recent years, although it is easy to overestimate the magnitude of the effect. In the three years ending February 2021, the correlation between monthly changes in the 10-Year Treasury Note yield and the performance of the Russell 1000 Value versus Growth has been +0.28. Taking a longer perspective shows that this has not been a particularly consistent pattern over time though, as we can see in Exhibit 1. The varying correlation of value’s relative performance means that value does not simply win when rates rise and lose when they fall despite the narrative of late.