Value or growth? First, diversify holdings

For more than a year, leading money managers have been anticipating a major change in the markets. According to their scenario, growth stocks will take over market leadership from value stocks and, in particular, large-cap growth stocks will start to perform more strongly and small-cap value issues will fade.

Even though the change has failed to materialize in a significant way, they remain convinced it eventually will take place. According to historical precedent and judged by quantifiable measures, they say, the change is inevitable.

But history seldom repeats itself in the same way and it’s only in hindsight that we can understand why some changes occur and others do not. Although the signs are there, therefore, no one can be sure if, when and how such a switch will take place.

In assessing their argument, let’s look first at what we do know – and what we can measure.

For more than five years, we have had a boom in small cap value stocks. (Value stocks are those that are considered to be trading below their potential as measured by price, earnings and other factors.) At the same time we have had a bear market in large-cap growth stocks. (Growth stocks are those whose profits and sales are growing more than the average for the industry.)

The figures tell the story: The Russell 2000 Value index, which measures movement in the small-cap value stocks, gained an average 14.8 percent a year for the five years ending Aug. 26, 2005, while over the same time the Russell 1000 Growth index, which measures large-cap growth stocks, fell 10.5 percent a year.

We know, too, that the difference between the two is at an extreme point. Value stocks, particularly the smaller ones, have grown so strongly that many now look more like growth stocks than value stocks.

We also know that value has beaten growth for more than five years now and that the historical average for value to beat growth is five years. We know, too, that historically spurts in growth stocks have been stronger than those in value stocks and have lasted around two years – and then the market has returned to favoring value stocks once more.

Over long periods of time, returns for value and growth stocks are more or less even, although value has a slight edge. Based solely on the historical record, therefore, growth’s time is due. Indeed, the asset class has catching-up to do.

But what we do not know is the start date, the duration and the percentage of any swing to growth that might occur. We do not even know whether the change will occur.

Sure, we can guess. But then many investors guessed about a year ago that the market would swing from value to growth. So far, it has not happened.

The mistake most investors make is to look backward and to decide that, because value beat growth in the past year, they should pour more of their money into value than into growth. That might have been right last year. But it might just as easily have been wrong. And now most managers believe we are much closer to the end of the value dominance than we were 12 months ago.

In 1999 many investors looked back, saw that large-cap growth was outperforming value, and invested accordingly. True, they were pleased with their choice as growth stocks soared, but eventually the market swung in the opposite direction and they were left without a safety net.

Those who were also invested at the time in value stocks were able to ride out the crash in much better shape as value stocks took over market leadership from growth stocks.

Now, should value stocks fall sharply, those who are heavily invested in value stocks might suffer a similar fate.

The key is to be diversified, with growth and value both represented in your portfolio. That way, you will be better prepared for the change if the analysts are right, but the chances of your portfolio suffering severely are reduced if they are wrong.

You might not become rich overnight, but you might be less likely to become poor overnight either.