Barron's reported in its March 19 issue on the widening disparity between growth and value mutual funds (unfortunately, the article is available for subscribers only).

On one side are value managers who can't justify the sky-high valuations of today's popular tech stocks, based on traditional metrics like cash flow, earnings, and so forth. On the other are growth managers who increasingly see a tech-driven "winner-take-all economy" where companies like Amazon and Google (Alphabet) swallow huge swaths of the marketplace whole.

This vast disparity in viewpoints shows up both in the current holdings of representative funds as well as in their recent performance. The article compares two funds that have spent time on SMI's recommended list in the past: growth-oriented Baron Opportunity and value-oriented Heartland Value. The average trailing 12-month Price/Earnings ratio of Baron's portfolio is 42; Heartland Value's is 7. But annualized returns over the past five years tilt just as heavily to Baron Opportunity at 14.2%, whereas Heartland Value has earned just 7.1%.

The article points out that this is hardly limited to this single pair of funds:

The median P/E of the 50 highest valuation funds in Morningstar's database was 37, versus 14 for the lowest-valuation funds. Of the funds with five-year records, the high-valuation growth funds returned 16% annualized, compared with 11% for low-valuation ones.

The rest of the article essentially argues the point that both types of funds are due to "regress to the mean" — i.e., that value funds represent the smart play going forward due to their currently-out-of-favor, but-due-to-rebound status.

Intuitively, that's an attractive approach. And historically, applying that type of value-driven style has worked well, although it sometimes requires tremendous patience, as these periods of underperformance can sometimes last far longer than anyone expects.

That timing element is the potential hang-up: how does one know when is the right time to make a switch to favoring an out-of-favor class? Most value investors perpetually favor these types of out-of-favor investing plays. But this leads to brutal periods of underperformance, as witnessed by the recent returns noted above. And few have the emotional fortitude to stay true to that discipline during extreme periods like this. The late 1990s were a good example, as growth trounced value by huge margins in the run-up of the tech bubble and a number of legendary value investors either threw in the towel and went out of business or capitulated near the top of the bubble.

Think different

SMI advocates a different approach: Upgrading. Rather than trying to predict (guess) when the market will shift from favoring one investing style over another, why not just follow its lead instead? By taking its cues from what the market is already doing, Upgrading helps us avoid being years too early on these types of trend shifts. After all, no one knows if 2018 will finally be the year value re-asserts itself and takes the lead. It could be 2019, or 2020, etc.

Granted, being trend-followers (as we are when we use Upgrading) rather than predictive investors who are trying to get in front of the next market shift before it happens, means we'll never be positioned for the opening stanza of a new market move. There's always an adjustment period as Upgrading shifts out of the old regime and gradually reinvests in the new leaders. But this process has, in the past, allowed us to harness the lion's share of the market's big moves. Bluntly, it spares us the tremendous risk of being way too early.

For example, in the late 1990s, Upgrading allowed us to capitalize on the growth stocks that led the way up in the bull market's final months (years, really), and then shifted to value-oriented fare quickly enough to avoid a good portion of the subsequent bear market's downside. That's the example that is most reminiscent of the current market's growth/value disparity.

Some will wonder how Upgrading accomplishes this, given that Upgrading is always invested in both growth and value mutual funds. Apart from the standard diversification benefit of always having some money invested in each type of fund (as well as owning both large and small companies), the key is understanding that Upgrading's category definitions are broad enough that within each risk category there is significant variation between funds.

Using the Large/Growth risk category as an example, this category of funds will contain a range of portfolios. On one side of the category will be funds that own the largest/growthiest stocks in existence. On the far opposite side of the category will be funds that own stocks just barely large enough to avoid the small category size cutoff, and likewise sit astride the value/growth style dividing line. During growth booms such as we're experiencing currently, Upgrading will select recommended funds from the largest/growthiest side of the category. But when the markets shift and those stocks fall out of favor, Upgrading will have the flexibility to shift to the smaller, more value-oriented funds that still fit within the Large/Growth group's broad parameters.

An easier path

The market is constantly transitioning as investors fluctuate between being dominated by fear and greed. Trying to predict when these changes will occur is an extremely difficult way to invest. Few, if any, are consistently successful trying to navigate these twists and turns.

That leaves investors with the option of either sticking with one approach all the time (i.e., being a true "value" or "growth" investor through thick and thin), and simply having to deal with the performance and emotional scars that come with riding out painful stretches of being terribly out of favor, or adopting a more flexible trend-following approach such as Upgrading. Naturally, Upgrading has challenges of its own, but we think they're easier to deal with — both from a performance standpoint and an emotional standpoint — than most alternative approaches.