Do You Find the post useful? Please share
Value vs growth investing is a no contest.
There’s a lot of debate around the philosophy of value vs growth investing. Value investing is the process of investing in stocks that are undervalued relative to their intrinsic value, while growth investing refers to the philosophy of investing in companies that have consistent earnings growth as well as the promise of above-average growth in the future.
Wall Street analysts and Ivy League academics may debate the differences between the two approaches, making it seem like one has to choose between one or the other but the world doesn’t always fall into neat little boxes; it’s clear that value investing is the only way to invest.
Learn more: define warrant
Value is the Winner
Research conducted by Ibbotson shows that value stocks have left growth stocks in their dust over a 40 year period spanning 1968-2008. This finding holds true for small, mid and large cap stocks.
Academics typically classify value stocks by sorting a list of stocks on various price multiples: price-to-earnings, price-to-cash, price-to-book, etc. These multiples are used to identify stocks with low prices relative to the aforementioned measures (value stocks). The stocks that have higher relative prices are defined as “growth stocks”.
Fama and French (1992) examined the performance of value stocks versus growth stocks in different markets across the globe and found that value stocks were the winner in twelve of thirteen markets. The study spanned 20 years, from 1975 to 1995 and is an extremely influential study in this area of research.
Bauman, Conover and Miller (1998) built on Fama and French’s research, further corroborating the evidence. They found that value stocks outperformed growth stocks in in a majority of 21 international markets over a 10-year period.
Capaul, Rowley and Sharpe (1993) found that value stocks selected using price-to-book ratios outperformed growth stocks in France, Germany, Japan and the UK between the years of 1981-92.
Not to belabor the point but a 90 year study from Bank of America in conjunction with Merrill Lynch found that value stocks generated an average return of 16.7% annually. Growth stocks did well, but could not match their value stock counterparts (12.4%).
See also: calculate book value of equity
All this to say, the outperformance of value stocks is a phenomenon that exists not just in US markets, but all over the world, and the finding holds across different time periods and methodologies.
There is one caveat: the BoA/ML study did find that growth stocks tended to outperform value stocks when the economy was contracting. Over the very long run however, you are better off with a value-based approach, with value stocks beating growth stocks in 3 out of every 5 years.
See more: trading terms definition
Why Value Wins the Value Vs Growth Investing Showdown?
Another study conducted by Bauman and Miller of Northern Illinois University give us some insight into why value stocks outperform on a consistent basis. The authors looked at a list of stocks broken out into 4 different groups, sorted by low to high price-to-earnings ratios. Group A, stocks with the lowest price-to-earnings ratios, were the ones that surprised most on earnings. In other words, these value stocks beat market expectations while the more expensive stocks tend to miss their high earnings target expectations, leading to relative underperformance.
It’s easy to see why growth stocks underperform when defining them this way, and reversion to the mean plays a big part. Essentially many of these studies define growth stocks as having high P/E ratios (or another single multiple, or a combination of a few different ones) and value stocks as having low P/E ratios then performance is negatively impacted by the group of growth stocks who move from high P/E groups to a lower P/E group over time.
In fact the effect is so pronounced, that if you were able to identify these stocks ahead of time and exclude them, then growth stocks could conceivably outperform value stocks. That’s exactly what George Athanassakos, Professor of Finance at Ivey Business School, found in his study of the Canadian market from 1986-2014.
The Final Word on Value Vs Growth Investing
The classification between value investing and growth investing is misleading. If one assumes the mindset of a growth investor, it is hard to imagine paying a premium for companies that show the promise of above-average growth. Investors do not want to pay more than they need to, which is why the philosophy of GARP is popular amongst growth investors. Growth at a reasonable price, GARP, is a strategy that combines the ideas of value and growth investing. Essentially, the idea is to find businesses that have consistently strong and increasing earnings but aren’t overpriced.
There’s a reason value investing is such a powerful strategy. By buying stocks at a discount to intrinsic value, an investor is able to protect their downside and build in a margin of safety. Margin of safety simply refers to the difference between the share price and intrinsic price per share. If you think about it, there’s a lot less risk in buying a million dollar company for $500,000 than for $2 million. Pair this pricing advantage with strong future earnings growth then you put yourself in a great position to take advantage of asymmetrical returns.
What people really consider growth investing is more like momentum investing: trying to ride the coattails of stocks that have shown strong growth in the past and are expected to continue growing in the future. Investing in this manner is basically equivalent to speculation.
At the end of the day intelligent investing is value investing, and screening for consistently strong earnings should be on any value investor’s checklist, and stocks selected using value investing principles can serve as the growth component of your overall portfolio. There’s no need to differentiate between two categories of stocks, instead expand your understanding of what constitutes intrinsic value.
Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.