Sooner or later, investors inevitably face a fundamental question: Do you believe more in value stocks or in growth stocks? Or to rephrase it for advisors: What do your clients favor?

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There may actually be a right answer. A mathematical examination suggests a strong reason for leaning toward value stocks. This exercise involves a close comparison of U.S. large-cap, mid-cap and small-cap equity indexes over a 23-year period, 1990 to 2012.

The performance of U.S. cash, U.S. bonds and U.S. equities are shown in the Comparing Performance chart on the next page. Also shown are the returns for value and growth indexes across three market capitalizations (large growth, large value, mid-cap growth, mid-cap value, small-cap growth and small-cap value).

From Jan. 1, 1990, to Dec. 31, 2012, the annualized return of the S&P 500 was 8.55%, and the standard deviation of these annual returns was 18.5%. An initial investment of $10,000 in the index in 1990 would have grown to $65,995 by the end of 2012 (not adjusted for taxes or inflation, and assuming no additional deposits or withdrawals).

Meanwhile, the 23-year annualized return of three-month Treasury bills was 3.33%, with a standard deviation of 2.2%; $10,000 invested in T-bills in 1990 grew to $21,265 by the end of 2012. The Barclays Capital Aggregate Bond Index had a 6.9% annualized return, a 4.8% standard deviation of return and a final account value of $46,427.

VALUE PREMIUM

The 23-year annualized return of growth-oriented large-cap U.S. equity was 7.6%. By contrast, value-oriented large-cap U.S. stocks in this study had an average annualized return of 8.55%. In the aggregate, large-cap value stocks generated a "premium" of 95 basis points over large-cap growth stocks over this period. In an account with a starting balance of $10,000, this premium amounted to $12,109 more for large-cap value stocks after 23 years.

The average 23-year return of two mid-cap value indexes was 10.19%, considerably better than the 9.16% average return of the combined mid-cap growth indexes. This 103-basis-point difference in performance amounted to a mid-cap value premium of $18,112 over 23 years.

Among small-cap U.S. equities, the value premium over the 23-year period was an astonishing 266 basis points. With a 23-year annualized return of 10.34%, small-cap value stocks turned $10,000 into $96,220; this was $41,384 more than the ending balance in the small-cap growth category, which had an annualized return of 7.68%.

FIVE-YEAR RETURNS

The information in this first chart reflects performance over a long period. Clearly, however, many of your clients won't be investing for that long - so it's useful to examine performance in smaller time frames, like five-year periods. The performance premium (or outperformance), whether for growth or value, is shown in basis points in the 5-Year Rolling Return Premiums chart on the next page.

From 1992 to 1996, for instance, large-cap value equities demonstrated a 240-basis-point premium over large-cap growth equities. Among mid-cap U.S. equities during the same period, there was a value premium of 203 basis points. Among small-cap equities, the five-year value premium was 363 basis points.

Considering all 19 five-year rolling periods shown, large-cap value demonstrates a performance premium in 58% of the periods. The average five-year value premium was 462 basis points. Conversely, large-cap growth outperformed large-cap value in 42% of the periods by an average of 302 basis points. The chart also shows the five-year rolling returns of the S&P 500.

In general, when the S&P 500 is not doing well, value stocks tend to outperform growth stocks. But in the four most recent five-year periods (2005-2009, 2006-2010, 2007-2011 and 2008-2012), the S&P 500 has produced anemic five-year rolling returns and yet growth has outperformed value. This is largely because one exceptionally bad year, 2008, is embedded in all four of those five-year rolling returns.

Among mid-cap equities, value outperformed growth in 53% of the periods, by an average of 548 basis points. During the 47% of the periods when growth outperformed value, the margin of victory averaged 289 basis points. Among mid-caps, a value tilt has provided better performance historically than a growth tilt. In three of the most recent five-year rolling periods, however, growth has outperformed value.

Among small-cap U.S. stocks, value outperformed growth in 84% of the periods by an average of 487 basis points. Yet in one of the rare periods when small-cap growth outperformed, 1995-1999, the difference for growth over value was 860 basis points. Overall, when small-cap growth outperformed small-cap value, the average margin of victory was 382 basis points.

LONG-TERM IMPLICATIONS

These findings do not argue for eliminating growth-oriented assets from a portfolio. They do suggest, however, that overweighting value stocks is justified in the long run - particularly among small-cap U.S. stock mutual funds.

As the length of the investing period increases (from one-year periods to three-, five- and 10-year rolling periods), value stocks tend to register a premium more frequently. Between 1990 and 2012, small-cap value stocks outperformed small-cap growth stocks in 57% of the three-year rolling periods, 84% of the five-year rolling periods and 93% of the 10-year rolling periods.

Based on this historical evidence, clients building portfolios that use U.S. equity funds might consider overweighting value and underweighting growth. The value premium is more pronounced among small-cap equities and over longer time frames.

Craig L. Israelsen, Ph.D., a Financial Planning contributing writer in Springville, Utah, is an associate professor at Brigham Young University. He is also the author of 7Twelve: A Diversified Investment Portfolio With a Plan.

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