Value stocks or growth stocks? It’s a decades-old debate that investors have been having since the dawn of financial markets. But, over the past decade, this debate has become significantly one-sided.
That is, growth stocks have just absolutely crushed value stocks for the past 10 years.
Perhaps more importantly, growth stocks have outperformed value stocks in every single year since 2011, except for one year (2016). In the following year (2017), growth stocks more than made up for it by outperforming value stocks by a then-record 11.9%.
Never before have growth stocks so consistently and significantly outperformed value stocks.
Of course, that prompts the question, why? What has changed over the past decade that has prompted an unprecedented run by growth stocks?
One thing: The Cost of Equity.
What ‘Cost of Equity’ Means
Many readers may not know what the Cost of Equity is – and those of you who do know, well, you probably don’t spend much time thinking about it.
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But make no mistake. The Cost of Equity is the single most important number for hypergrowth investors.
So … what exactly is the Cost of Equity?
The Cost of Equity takes on many definitions. But with respect to this discussion, the Cost of Equity wears the hat of “the required rate of return on an investment in equity.”
It’s basically the annual rate of return you would require as investor to be invested in a stock. There are many puts and takes in arriving at that required rate of return, but according to the Capital Asset Pricing Model, it can be calculated as follows: Cost of Equity = Risk-Free Rate + Equity Risk Premium.
Where the risk-free rate is a proxy of the return you could get by investing in a risk-free instrument – like a Treasury note – and the Equity Risk Premium is the additional return you require for taking on the risk of investing in a stock (that isn’t guaranteed to go up).
The Cost of Equity, therefore, oscillates with interest rates and perceived economic health.
When interest rates are high and perceived economic health is low, the risk-free rate is high and the equity risk premium is high, resulting in a high Cost of Equity.
On the flip-side, when interest rates are low and perceived economic health is high, the risk-free rate is low and the equity risk premium is low, resulting in a low Cost of Equity.
Why Cost of Equity Matters to Growth Stocks
Now … why does any of this Finance 101 jargon matter? Because the Cost of Equity drives stock prices.
The calculus is a bit complex, and requires a discussion of discount rates, net present value, and discounted cash flow models. But, at a high-level, the concept is simple enough to understand without that discussion.
When the Cost of Equity is high, the present carries more value than the future, because the future is being discounted at a high rate. Therefore, value stocks – which carry more present-value than future-value – outperform.
When the Cost of Equity is low, the future carries more value than the present, because the future is being discounted at a low rate. Therefore, growth stocks – who derive most of their value from future expectations for growth – outperform.
And so we come full circle to answering our question: Why have growth stocks outperformed value stocks in an unprecedented way throughout the 2010s?
Because the Cost of Equity has been unprecedentedly low.
In response to the 2008 Financial Crisis, the U.S. Federal Reserve slashed interest rates to zero, causing the risk-free rate to plunge. Meanwhile, against this zero-rate backdrop, the U.S. economy has been chugging along, slowly but surely, resulting in a low-to-normal equity risk premium.
The result? A record-low Cost of Equity.
Throughout modern history, the U.S. Cost of Equity has normally hovered narrowly above 10%, per various estimates. According to Duff & Phelps, the Cost of Equity has been below that 10% average since January 2012 – and presently sits around record-lows of 8%.
That basically means that, for decades, investors have been discounting future returns and growth expectations by 10% per year. Now, they’re discounting future growth by just 8% per year.
This has resulted in the lopsided dominance of growth stocks over value stocks for the past 10 years.
And the reality is that long as the Cost of Equity remains low, growth stocks will keep smashing value stocks.
Bottom Line on Growth Stocks vs. Value Stocks
Luckily for hypergrowth investors, the Cost of Equity projects to remain low for the foreseeable future.
The Fed has essentially committed to zero interest rates for the next three years to help stimulate an economic recovery, while that economic recovery is moving along quite nicely and should get a big boost in 2021-22 from Covid-19 vaccine distribution.
The result? A “Goldilocks economy” with low rates and good growth. That means a low risk-free rate, a low equity risk premium, and a Cost of Equity that continues to hover in the 8% range.
As long as that number remains in the 8% range, growth stocks will continue to outperform.
So forget the naysayers pounding on the table about a “value stock reversal.” They’ve been pounding on the table about that for years now. And, much as they have been in the past, they will continue to be wrong.
Because, at the end of the day, all that matters in the growth stocks versus value stocks debate is the Cost of Equity.
With the Cost of Equity set to remain lower for longer, growth stocks are set to keep stealing the show on Wall Street.
On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.
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