Growth vs Value Investing: Who Wins?
When it comes to investing in financial markets, there are a lot of different opinions about the best strategy. Over time, some perform well… then perform poorly after their ‘honeymoon’ period. This almost always seems to be the case with ‘successful’ strategies. The reality is if a strategy is successful, others copy and sooner or later, the strategy’s success is eroded, sometimes even causing negative returns if prices inflate too high.
One of the oldest and most contested battles between opposing investment corners is between so-called growth and value investing. The ‘father’ of growth investing to some is Thomas Rowe Price, Jr who set up the T. Rowe Price flagship growth investment fund achieving a 15% average annual growth rate over 22 years. 1 The ‘father’ of value investing, Benjamin Graham, wrote the books ‘The Intelligent Investor’ and ‘Security Analysis’ – both extremely influential in the financial world. Graham’s investment performance was equally as successful as Price’s. From 1936-1956 Grahams average performance was around 20% annually compared to the market’s average of 12.2% over the same time 2. One of Graham’s many disciples is Warren Buffet, who even wrote a piece in the later editions of Graham’s Intelligent Investor.
What exactly are the two investment styles?
The aim of growth investing is of course to grow the initial capital invested. Growth strategies do this by investing in potentially smaller companies with great growth potential in the future, or even in bigger companies are projected to expand (think technology stocks at the moment). The hope is the investments dramatically increase their earnings – at faster rates than the market, driving up the company’s value. Investors then sell their portfolios with a large premium over initial prices. High profile growth stocks in the past have been IBM during the ‘70s; Microsoft during the ‘00s and more recently, Tesla (NASDAQ: TSLA). In fact, an investment in Tesla a little over a year ago would’ve grown by 900%! Researchers looking for new growth stocks may take multiple factors into account: company earnings growth potential, industry growth potential and potential to generate a high return on equity.
One common characteristic of growth stocks is that their future earnings potential is sometimes incorporated into the current price. It is therefore not unusual to observe growth stocks trading at large premiums compared to their tangible assets. This is called a low book-to-price ratio (B/P) where book refers to the book value of a company’s assets. Prices of assets are said to reflect the total value of future cash flows from the asset. So, by definition, so-called growth companies are assumed to have large expected future profits. Investors, therefore, pay a lot, for sometimes very little, until the stock realises its potential. Along with low B/P ratios, growth stocks often tend to have high price-to-earnings ratios (P/E), reflecting the relatively high prices of the stocks compared to their current earnings.
Simply investing your savings into the next Telsa is not as easy as it may seem – companies like Microsoft and Amazon do not come around too often. Investing in individual growth stocks can be very risky. There are many more failures than success stories (look at the dot com bubble for instance where technology growth stocks crashed in early 2000’s). This risk is exacerbated when taking into account the inflated prices investors pay for their flashy new growth stocks. A way to combat this risk is to invest in funds of growth stocks that invest in multiple companies. By doing so, investors can spread the risk of being exposed to the failed prospects, and simultaneously increase the chance of owning a piece of the next Tesla’s pie.
Value investing is the opposite of growth investing in most ways. Value investing strategy aims to buy stocks below their fundamental ‘fair’ value 3, usually stocks that priced abnormally low compared to their industry. The plan thereafter is that the market price (which is suggested to be relatively accurate in the long run) will eventually reflect the true value of the stock. There are a couple of reasons why stocks may trade below their value: short term poor profits, current bad press, general low opinions of the firm/ industry. The general principle is simple; if you know a company’s value, you can save money by purchasing it at a discount like any product. When its price eventually rises again, simply sell the stock you bought at a discount for a premium.
Value stocks tend to have high B/P ratios as the value of their assets are relatively high in comparison to their price. They may also have relatively low P/E ratios again owing to the discounted price. Value investments, therefore, come with the added bonus of reduced downside risk – in the worst-case scenario (bankruptcy) the assets of the company can be sold off and its shareholders receive some of the proceeds. Intuitively, higher B/P ratios mean when buying value stocks, investors purchase more tangible assets per pound invested.
An example of the value investing formula inaction could’ve been Fitbit (NYSE: FIT) during 2016. Fitbit realised its Q1 earnings on 4th May 2016 and saw a 19% decline in its price despite beating the market analyst’s expectations with earnings up 50% form the same period a year before 4. However, Fitbit had invested heavily in research and development throughout the year meaning its earnings per share (EPS) had actually fallen causing non-fundamental investors to abandon the stock. The intrinsic value of the company had not changed as a result of the R&D spending, but investors thought the reduced earnings was a bad sign.
Comparing the Strategies
The debate over the best strategy is still ongoing with no definitive answer. Two researchers who aimed to conclusively decide the best strategy were Fama & French. They derived a model to explain more of stock price deviations than the traditional CAPM model (this is the traditional model used to determines a stock’s returns). The model they created is:
The technicalities of the model are not important, only what the final term of the model implies. is the coefficient for the effect of “High minus low” book value. i.e. the difference in returns between value and growth stocks. Throughout their extensive research, they found to be positive suggesting that value stocks tend to outperform their growth counterparts.
Do we have an answer then?
Not exactly… The above graph seems to show a different story to the Fama-French one. Over the past 25 years, on average, growth stocks have outperformed value stocks and the gap is widening. This is being exacerbated during the pandemic as technology stocks seem to be booming whilst other areas of the economy are suffering – technology stocks are, more often than not growth stocks.
However, all is not lost for believers of value investing. The increased attractiveness of growth stocks has inflated their prices whilst simultaneously lowering the prices of value stocks. With growth stocks continuing to rise, and value stocks seeming more and more unattractive, does this not facilitate an environment where value stocks are set to regain the crown in the future? By casting our minds back to the beginning of this article, we can see that Graham’s success was during the 30s-50s, followed by Price’s success in the 50s-70s. Could the successes of the two strategies seem to be almost cyclical? Maybe in the not-too-distant future, we will once again see a resurgence of value investing.
A Final Comment
The Fitbit scenario mentioned earlier is a fine example of the risks associated with both strategies. Fitbit, once a growth stock that was expected to grow exponentially throughout 2016 declined drastically over the remaining part of the year highlighting the fundamental risks with growth stocks. Likewise, the seemingly discounted price of Fitbit after its bad press also turned out to also be a bad investment. R&D failures, along with poor management, caused the stock to decline further after the initial slump.
No matter what strategy investors use, nothing is guaranteed.