Value versus growth investing

What's the difference and which approach is the best for you?

Whats the difference?

Growth stocks are often characterized by companies with cash flows or earnings that seek to grow at a rate more rapidly than the broad market. They generally do not pay dividends, but rather reinvest earnings back into the business. This is done in the form of research and development, more staff, investments in equipment and acquisitions.

Growth stocks typically have revenue growth rates in excess of 20% per annum and tend to be smaller and younger companies. However in todays market many mature companies like Microsoft and Amazon are continuing to grow rapidly.

Value stocks are characterised by companies with solid fundamentals that are often trading below their book value. They often share earnings with investors in the form of dividends, through bull and bear markets. In a nutshell, growth stocks represent companies with future potential while value stocks represent companies that are undervalued.

Value investors are more concerned about the valuation of the company and finding a bargain. This is because stock prices often deviate from there true worth or intrinsic value. Value investors then try to identity stocks with good fundamentals that are trading for less than what they believe they should be, based on fundamental analysis and research of the industry and business. By buying and holding these companies the investors will profit when the stock price eventually return back to its fair value. Some value investors even go as far as to invest in declining or bankrupt companies if they believe they will receive more than what they put into the company after liquidation.

One of the most popular ratios used by value investors is the PE ratio (price to earnings). The ratio determines how much an investor would have to pay for each dollar of profit the company receives. Thus a stock with a lower PE ratio relative to other companies in its industry may be seen as undervalued. On the other hand growth stocks usually trade at very high PE ratios or the PE ratio may not even be able to be calculated if they are not yet profitable. This means investors have a high level of conviction in the company and believe that their future growth will be greater than the premium they are paying on the stock now.

Historical Performance 

Conventional investing wisdom often touts that in the long run value stocks outperform growth stocks. But do the facts back this up? Historical market returns from Bank American show that since 1926 value stocks have generated more than double the returns of growth stocks on the basis of cumulative returns. The two approaches are usually benchmarked using the Russel 1000 value index as well as the Russel 1000 growth index.

Value investing has stood the test of timethrough various US market cycles. Some of the cycles that have had far-reaching impacts on capital markets include:

The Roaring 20s
The Great Depression
WW2
The 1970s Oil Crisis
The DotCom Bubble of the 1990s
The Global Financial Crisis of 2008

The fact that historically value stocks have returned roughly double that of growth stocks may make it seem like the clear winner when making investment decisions. However, the decision between value and growth is not as black and white as it seems and recent market returns paint a very different picture. In recent years growth stocks have outshone value stocks leading many seasoned investors to wonder whether the value investing strategies followed by Graham and Buffet are still relevant in today's market lead by technological innovation.

However, despite the advantage value investing has played over various market cycles growth stocks have been the clear winner since 2007. Most young investors, myself included, havent been in the market long enough to first hand experience the impact long drawn out economic recessions have had on markets. Thus it is hard to second guess the attractive returns growth stocks have had over the past two decades even though more conservative value-driven approaches have stood the test of time.

Trying to ride the wave 

The changing tides of favour between value and growth may cause investors to chase market returns by following whichever school of thought is currently performing best. This has been particularly true for growth stocks in recent years.

Because growth stocks have outperformed value stocks for more than a decade, investors have been channelling funds into growth companies. This has also been accelerated by stimulus from the federal reserve.

There is some evidence that the outperformance of growth stocks is nearing an end. The Buffet Indicator which compares the total market capitalization of US stocks to GDP is approaching an all-time high at just under 200%. This essentially means that the US stock market is currently worth twice as much as GDP. This leads analysts to believe that markets are currently overvalued and there may be a rotation towards value stocks if I stock market crash were to take place.
 

A study by J.P. Morgan concluded that value stocks could outperform growth stocks in a recession or if inflation and interest rates rise. While predicting when the next recession or big interest rate hike will occur is almost possible to do, there is no doubt that they will occur eventually.

Closing Thoughts

Value investing has outperformed growth investing in the long run when looking at the past 100 years. This is mainly due to changing economic climates which can last for extended periods of time. When looking at shorter periods of time though the case is less convincing.

Over the past decade, the Russel 1000 growth index has returned 17% annually while the Russell 1000 value index has returned just 10% annually. Many see this as a fundamental change in the markets brought about by technological innovation. However, it is important to note that similar arguments were made leading up to the dot com bubble in 2000 and as many of us are aware the four most dangerous words in investing are this time is different. Thus depending on your time horizon, this may not be an easy choice. A prudent approach would suggest holding both value and growth stocks in your portfolio.