Value stocks are the ones that usually trade at a relatively lower multiple like price to book (P/B), price to earnings (P/E), enterprise value to EBITDA (EV/EBITDA), or just simply are at a discount to their intrinsic net worth, often known as the discounted cash flow (DCF) valuation. Growth stocks are usually the ones that have higher growth potential. A company being relatively early in its industry life cycle, delivering a new technology or product can be a few reasons fueling this growth, which is often reflected in the company's sales or earnings number.

Value stocks have underperformed growth stocks for over a decade now. This can be observed through the valuation of sectors like financials, industrials, and materials. Growth stocks have outperformed every other factor over the years, the perfect example would be the FAANG (Facebook, Amazon, Apple, Netflix, and Alphabet's Google). Sectors like technology and biotechnology comprise mostly of growth stocks and tend to trade at higher valuations.

Image source: Getty Images.

An important factor to consider here is the business cycle. Investors usually buy growth when the economy peaks as these are periods of technological innovation or disruption. Investors prefer rotating into value when we get to the end of the cycle as, during a bear market, lower-valuation stocks tend to fall less than more expensive growth stocks and their higher income offers a buffer for total returns.

An average cycle may range from seven to 10 years, the most recent cycle started after the 2008-09 crisis and is overextended, according to some analysts.

Value often outperforms in the early stages of recovery. This has happened in almost every cycle and can be observed through the MSCI world growth vs. value relative performance index. When the index is lower, value outperforms growth, and vice versa. A big dip after the dot-com bubble crash shows a rally in value, but the dip was relatively smaller in the 2008-09 slowdown.

The latest value rotation started mid-August 2019 when long-dated sovereign yields (U.S. Teasuries with maturities of more than 10 years) set their lows for the year. Smart-beta ETFs, which track a particular style or sector, experienced $2 billion in inflows in Value ETFs in the third quarter and outflow of roughly the same amount in growth ETFs, which were trending early in the year.

Value ETFs like Vanguard Value ETF (NYSEMKT: VTV) and The iShares Edge MSCI USA Value Factor ETF (NYSEMKT: VLUE) are both up 3.5% in the last six months. Both of these closely track U.S. mid-cap and large-cap value stocks like AT&T -- up 16%; Intel -- up 30%; and Goldman Sachs -- up 12.7%. The iShares value ETF (up 20% year to date) has also caught up with the iShares US Momentum ETF (NYSEMKT: MTUM), which is up only 19% year to date. MTUM tracks high-momentum U.S. large- and mid-cap stocks like Microsoft, Mastercard, and Visa, and has grown substantially over the years.

Some investors believe that this is phase one and only 20% of rotation is complete, while others think that the rotation won't last long as this represents traders covering for their short positions. What happens next in the U.S.-China trade war and the fundamentals of the global economy is important as better macro data and cycle recovery should drive the second phase of this rotation.

Image source: MyWallSt.

MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in the companies mentioned above. Read the full disclosure policy here.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Facebook, Mastercard, Microsoft, Netflix, and Visa. The Motley Fool owns shares of Vanguard Value ETF. The Motley Fool recommends Intel and recommends the following options: long January 2021 $85 calls on Microsoft and short January 2020 $50 calls on Intel. The Motley Fool has a disclosure policy.

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