Since the financial crisis, growth stocks have dominated value stocks and produced the bulk of market gains. The top seven largest companies in the S&P 500 are all big tech firms like Apple (AAPL -0.81%) and Microsoft (MSFT -0.66%), while the top 10 largest S&P 500 components contributed around half of the entire S&P 500's gain in 2021.
A stock market led by growth can be explosive, but a stock market led by value offers many investors a more attractive risk-reward profile. Here are three reasons why the return of value investing could be good news for you.
Image source: Getty Images.
1. Growth stocks have gotten expensive
Between 2019 and the end of 2021, Apple and Microsoft added $4 trillion in market cap to the S&P 500 after Apple gained 364% and Microsoft gained 242% in that three-year time frame. Both companies are incredibly well-run businesses, but even Apple and Microsoft can't grow revenue, earnings, or free cash flow (FCF) quickly enough to keep pace with that level of price appreciation.
As a result, both company's valuations have ballooned well above their five-year medians.
AAPL PE Ratio data by YCharts
With the largest components of the S&P 500 looking expensive, it makes sense that the market would turn to sectors outside of tech to contribute a higher portion of the index's gains in 2022.
2. You can better understand what you own
Investors like Ark Invest CEO Cathie Wood are in the business of finding paradigm-shifting growth stocks that have the potential to disrupt industries and produce market-beating returns over time. While these businesses have a lot of upside, they can also be difficult to understand, hard to value, and incredibly volatile stocks to own. Taking a small position here and there in an exciting growth stock makes sense for many people. But allocating the lion's share of your savings toward high-risk, high-reward growth stocks is a game that few should probably play.
For most investors, investing in a company that you understand and believe can grow over time can be a better long-term strategy. It may produce fewer returns than a more aggressive style, but it will probably be less volatile and lead to fewer sleepless nights.
Companies like Procter & Gamble, Starbucks, and McDonald's are easy-to-understand, industry-leading businesses that pay dividends. Similarly, industrial stocks like Caterpillar, Honeywell, and Waste Management provide products and services that surround our everyday lives -- construction services, thermostats, and the collecting, transporting, and disposing of trash.
Owning a business that you understand can help you battle the mental side of investing by sticking with a company during a sell-off and adding to the position if the market gives you a cheaper price.
3. It's a better market for retirees and passive income investors
Growth stocks tend to be volatile and not pay dividends, while many value stocks pay attractive dividends that can supplement income in retirement. A market led by value stocks is better for retirees or folks interested in generating passive income. Value stocks tend to have a risk/return profile better suited for retirees. Sometimes, boring investments are the best investments. Laundry detergent, soap, and McMuffins may not be as exciting as the metaverse. But the companies that make those products tend to generate stable organic growth even during recessions. That's the kind of business model that investors who can't afford to lose their investment principal depend on.
It's too early to tell if we're in a period of transition away from growth toward value. What we do know is that energy, industrial, financial, healthcare, and consumer staple stocks are leading the market right now because they are suited to perform in an inflationary, higher interest rate environment.
Changing of the guard
Investors with a higher risk tolerance now have a chance to buy many blue-chip growth stocks on sale, which is particularly great news for young investors or those just starting out.
If the stock market sell-off persists, it could be a good idea to take the glass-half-full perspective by seeing it as a chance to buy or as a way for sectors outside of tech and consumer discretionary income to contribute market-beating gains.
