Growth vs. value stocks: Growth's streak may be over

— -- Q: Why do "growth" stocks continue to outperform "value" stocks this year?

A: Among investors, the growth vs. value debate gets as heated as Pepsi vs. Coke or McDonald's vs. Burger King.

Before I explain the debate and why growth stocks have been doing better than value stocks lately, it might be helpful to provide some quick background.

Essentially, value stocks are the beaten-up and overlooked stocks on Wall Street. There are ways to measure this, namely the price-to-book ratio. But, it's easier to think of value stocks as shares of companies that might be in mature, low-growth areas of the economy or stocks that those buying them believe are just undervalued by other investors.

Growth stocks, by contrast, are stocks of companies that seem to have the world in front of them, with boundless growth opportunities in exciting, often new, industries.

Historically, value stocks have done better than growth stocks. Between 1927 and 2006, large U.S. value stocks rose 11.6% a year on average, topping the 9.4% average annual return of large U.S. growth stocks, according to IFA.com.

Value stocks tend to outperform growth stocks for a simple reason: Optimism. Investors buying growth stocks are betting that the company's growth can keep accelerating, causing earnings to beat expectations. Growth investors tend to get so caught up in the momentum. They don't mind the price they're paying, betting that earnings will make good on the promise. But bad things can happen to good companies, and many of the people who pay up, betting on momentum, get hurt.

Meanwhile, investors who buy value stocks are paying realtively cheap prices, or as they say on Wall Street, low valuations. Certainly, some value companies will stumble and may even go out of business. But not all value companies will, and because investors paid more reasonable prices up front, they stand to benefit when the companies deliver.

With all that said, the value vs. growth theory hasn't help up the past couple of years.

The Vanguard exchange-traded fund that owns large U.S. growth companies vug has beaten the value counterpart vtv in 2009 so far, the past year and the past three years.

How can that be? Part of the reason value stocks are struggling is that financial stocks have historically been a big part of value indexes. With smaller banks vanishing and larger ones getting clobbered, the value indexes are hurting. Meanwhile, investors continue to pay lofty valuations for growth stocks, thinking they will outgrow their problems and defy the recession.

That's why Rob Arnott, chairman of investment research firm Research Affiliates, believes growth's outperformance is nearing its end. He says investors are pushing prices, or valuations, of growth stocks to unheard of levels relative to value stocks. Meanwhile, value stocks are getting punished as investors price them for collapse.

Arnott says many companies in mature industries, from banks to airlines and autos, stand to benefit once the recession ends, because there will be less competition. "This points to a spectacular opportunity to shift focus from growth stocks to value stocks," he says.

Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Click here to see previous Ask Matt columns.