Why is it that great companies don’t always make great investments? This is a conundrum that’s long puzzled investors because it so clearly flies in the face of intuition. Indeed, today’s market leaders—companies like Apple, Amazon and Microsoft—are impressive businesses, and their stocks have delivered equally impressive performance, so much so that they and their peers have been dubbed the “Magnificent Seven.” The others in this group are Google parent Alphabet, Facebook parent Meta, chip maker Nvidia and Tesla. So it’s hard to believe that the stocks of great companies like this don’t turn out to be the best investments. But that’s what the data says.
Despite their glittering reputation, growth stocks have underperformed their humble counterparts on the value side of the market. Value stocks include old-line manufacturers, banks, insurance companies and the like. Over the past roughly 60 years, according to data compiled by Larry Swedroe in his book Enrich Your Future, an index of value stocks returned 13.2% per year while growth stocks returned just 10.0%.
This data seems so clearly upside down that it can be hard to believe. Both intuition and recent experience suggest the opposite would be true. Over the past 10 years, all of the Magnificent Seven stocks have outperformed the S&P 500 by hundreds of percentage points. While the S&P has returned a cumulative 180%, Apple has gained nearly 900%, and Amazon has returned 1,000%. Nvidia, benefiting from the growth in artificial intelligence, has risen 25,000%. So how is it that the long-term data suggest these aren’t the best investments?
It’s not just anecdotal evidence that would lead investors in the direction of growth stocks. Basic logic would also lead us in this direction. While not always moving in lockstep, stock prices do, on average, tend to rise and fall in response to corporate profits. So it stands to reason that investors would want to invest in companies with faster earnings growth since—all things being equal—that should translate into faster share price gains. But the data says otherwise.
How do we explain this disconnect? There are several factors. For starters, today’s Magnificent Seven stocks capture all the attention, but they’re outliers and aren’t representative of growth stocks as a group. As I’ve noted before, research by Hendrik Bessembinder, a professor at Arizona State University, has shown that just a tiny fraction of stocks, only 4%, are responsible for nearly all of the stock market’s net gains relative to Treasury bills. In other words, as terrific as these seven have been, they are also unusual, so we shouldn’t draw broader conclusions from this small set of outliers.
If we put aside the outliers, why do other seemingly great companies not deliver great stock market returns?
One key factor is that, when it comes to growth stocks, emotion plays a disproportionate role. People fall in love with these stocks in ways that they would never fall in love with a value stock. I’ve seen this in my own experience. On several occasions, folks have asked me to “never sell my Apple.” They don’t make these sorts of requests about banks or insurance stocks. Love can be fleeting, though. If a company isn’t delivering results that meet investors’ lofty expectations, they’ll be much quicker to abandon the stock, and this can drive the share price down. Growth stocks tend to be popular with short-term traders, and that can exacerbate this dynamic. The result is that growth stocks might do well for a while but then drop off.
Value stocks, on the other hand, are less well known and certainly less loved. Expectations are much lower. As a result, there aren’t as many prospective buyers bidding up their shares. The result is that value stocks tend to have depressed valuations relative to their earnings. But over time, as these companies deliver results that exceed low expectations, their share prices move up. That contributes to their outperformance.
Fast-growing, profitable companies are also magnets for competitors. As a result, ironically, highly profitable companies can end up sowing the seeds of their own decline. Think of BlackBerry, which had the smartphone market to itself for a time. But it didn’t take long for others to take notice and enter the market. This is a common pattern. Years earlier, the same thing happened to Kodak, when Fuji entered the market. Aspiring entrepreneurs, on the other hand, rarely get out of bed and decide to go compete with the local trash hauler or chemical manufacturer.
Fast-growing companies also tend to attract regulatory scrutiny, which ultimately can dent profitability. Just this week, in fact, the government opened a probe into Nvidia. Other market leaders, including Microsoft, Google and Meta, always seem to be responding to inquiries.
There’s another, more technical reason why growth stocks have lagged, on average: They’re more susceptible to interest rate changes. That’s because a large part of the value of a fast-growing company lies in its future earnings. When investors pay 30 or 40 times earnings for a growth stock like Nvidia, what they’re betting on is that the company’s future profits will eventually catch up with its current share price.
But with value stocks, investors aren’t betting on much future growth. Consider a company like Corning. It’s a fine company, but it’ll probably sell about as much glass next year as it did this year. For that reason, its share price doesn’t rely very heavily on future expectations. Its value is more heavily weighted toward the present than is the case with an Nvidia. And since a dollar today is worth more than a dollar tomorrow, and since future dollars need to be “discounted” using an interest rate tied to prevailing rates, that makes growth stocks much more vulnerable to interest rate changes.
If we accept the data that growth stocks—excluding the likes of the Magnificent Seven—have tended to underperform, what conclusions can we draw? In my view, this data is a key reason to avoid stock-picking and instead to opt for index funds. When picking stocks, it’s all too easy to be lured by the most well-known names, which are almost always highflying growth stocks. This phenomenon, dubbed the Magazine Cover Indicator, has been documented.
When you opt for an index fund, you’ll still own those growth stocks—so you’ll still benefit from the next Apple or Nvidia—but at the same time, you’ll own stocks on the value side. Those are the stocks that don’t make it onto magazine covers, but do, according to the data, tend to outperform.
For most investors, a simple S&P 500 or total-market index fund is sufficient to cover U.S. stocks. But if you have the inclination to do a bit more, you might also include a fund which tracks a value stock index. Since the S&P 500—and by extension, the entire market—is currently skewed toward growth stocks, this is a way to help tilt your overall portfolio toward a more even mix.
