Analysts have documented how value and growth investing fall in and out of favour by creating stock market indices of the two disciplines. They have been less successful in predicting which of the two will surge ahead at any given time.

Where are we in the value/growth cycle? According to research by William Sterling, chief investment officer for New York-based Trilogy Advisors LLC, growth stocks are now cheap relative to value stocks. In fact, he says, there is a strong case to be made that value is overvalued.

Historically, most of the growth and value indices simply ranked all stocks in a given stock universe from top to bottom in terms of each company’s price/book value. Stocks in the top half of the ranking — the expensive stocks, in terms of this measure — were classified as growth stocks. Stocks in the bottom half were value stocks. As gains increase among any group of stocks chosen by value criteria, however, they lose their attraction for value investors. Despite the change, value tends to win the race.

Over the past 30 years, growth stocks have underperformed value stocks by about 1.7% a year on a total return basis, which includes both price appreciation and dividends. Most of the difference has been a result of the fact that the cheap value stocks paid higher dividends, with average dividend yields 2.1% higher than for growth stocks. The dividend advantage made up for value stocks’ modest lag in price appreciation.

Yet, value/growth performance comparisons have been highly sensitive to the period chosen, Sterling maintains. For example, looking at data from 1975 through 1999, growth stocks outperformed value stocks by 2.2% a year on a total return basis. During the decade of the 1990s, growth outperformed value by a whopping 6.5% a year.

By the start of 2005, value had outperformed growth by an even larger 11.2% a year over the previous five years, he says, even more extreme than the 10.2% a year by which growth had outperformed value over during the 1995-2000 period.

When growth has beaten value, historically it has tended to do so over periods of 18 to 24 months, says Erik Ogard, an analyst with Frank Russell Group in New York. But growth has not beaten value for that length of time for 10 years. In addition to value winning by a large magnitude lately, therefore, the market has experienced an unprecedented time period in which value has beaten growth.

As a result of the performance differential, growth stocks now look relatively cheap compared with value stocks, Sterling says. Compare the price/earnings ratio of growth stocks with the P/E ratio of value stocks: heading into 2006, growth stocks have an average P/E ratio that is only 34% higher than value stocks, compared with an average premium of 55% since 1980. That represents the cheapest relative valuation of growth stocks since 1994, Sterling says.

In terms of price/book value comparisons, growth stocks recently had the smallest premium to value stocks since 1974. Growth stocks now have an average price/book value ratio about 75% higher than value stocks, which compares with an historical premium of 170%, or almost twice as high as the recent reading.

Looking at five-year rolling returns, Sterling found the initial relative valuation of growth vs value stocks explained more than half of the subsequent value/growth performance gap, even taking dividends into consideration. The logic is simple: when growth stocks were cheap relative to value stocks, it meant they were out of favour and subsequently outperformed. When growth stocks were expensive relative to value stocks, investors fell in love with them and they subsequently underperformed.

Sterling says earnings are high relative to the historical trend for both growth and value stocks. However, there is one critical difference in the data: although earnings for growth companies are modestly higher than their historical trend, earnings for value companies are massively higher than the historical trend.

Historically, when growth stocks are as cheap as they are now relative to value stocks, they subsequently outperform value stocks by 5.6% a year over the next five years, Sterling observes. Although “past performance is no guarantee of future results,” the historical data does support his thesis. IE