Value, Emerging Markets Will Continue to Win

By now you're probably tired of predictions for 2007, so I'll spare you my thoughts on where the market is headed this year. However, in the course of conducting our research on exchange-traded funds, we've arrived at a few conclusions that are contrary to the prevailing wisdom.

Value continues to outperform growth. Value stocks have outperformed growth stocks for six consecutive years, about as long as growth predominated in the late 1990s. As a result, many strategists are forecasting an imminent reversal in fortune in favor of growth. But I believe that the excesses of the late 1990s were such that growth stocks are still relatively overvalued.

It's a dirty little secret, but the methodology used in selecting constituents for inclusion in the iShares S&P 500 Growth Index(IVW) and iShares S&P 500 Value Index(IVE) funds isn't particularly good at separating companies with fast earnings growth from those with slow earnings growth.

What it primarily seems to do is separate expensive stocks from cheap ones, on the apparent presumption that expensive ones are priced that way because they will deliver rapid earnings growth -- in a sense putting the cart before the horse. But since 2000, stocks in iShares S&P 500 Value have delivered faster compound earnings growth than the stocks in iShares S&P 500 Growth!

That's not to say growth stocks won't ever increase earnings faster than value stocks. In fact, this year companies in the iShares S&P 500 Growth Index are expected to grow earnings 10.6%, compared with growth of just 8.1% for companies in the iShares S&P 500 Value Index (although the value fund trounced the growth fund in 2006, with earnings growth of 18% and 11%, respectively).

But the point is that stocks in the growth index cannot be depended on to produce superior earnings growth over the long term. So it is unlikely that, in an environment of overall slowing in earnings growth, (S&P 500 EPS growth is expected to slow to about 9% in 2007 from about 14% last year) where estimates are cut more often than they are raised, investors will be patient waiting for the ethereal promise of growth to materialize.

Value Trumps Growth Compound annual growth rate in earnings per share from 2000 to 2006

Source: AltaVista Independent Research

The iShares S&P 500 Growth Index currently trades at about 16.4 times estimated 2007 EPS, compared with 13.9 times for the iShares S&P 500 Value Index. Remember, just because you "pay up" for earnings growth doesn't mean you'll get it.