Made popular by legendary investors like Warren Buffett, value investing has been out of vogue recently, as investors clamour for growth stocks. Although many headlines suggest that value investing might be dead, there is a long history of these approaches ebbing and flowing; growth hasn’t always outperformed. Value or growth could be the right investing strategy, depending on our goals and objectives. Typically, the investor who focuses more on their goals and the long term will be the one who finds success, regardless of whether value or growth outperforms.
The essence of value investing involves investing in companies that are “cheap”. These companies typically have a low valuation, by looking at the ratio of share price to measures of ongoing fundamental value, such as earnings (profits), cash flow, dividends, or book value of equity. Value investors in turn anticipate that the cheap firms’ valuations will rise to the level of their average peers, with their share prices rising commensurately.
In the 1990s, extensive research from Fama and French1 and Davis2 indicated that the value style had rewarded investors on a risk-adjusted basis since at least the 1940s. The thesis at the time was that if it worked consistently in the past, it had a good chance of doing so in the future.
General characteristics of value investing:
- Expected to outperform in downturns, but underperform in the later stages of a business cycle/stock market cycle;
- Can be found in all sectors, but typically associated with stable sectors such as Financials, Utilities, Consumer Staples, and Industrials;
- Contrarian in nature; value companies are often out of favour with the majority of investors, especially during strong bull markets; and
- Long-term focus; investors expect to hold value stocks for several years.
Growth investing involves companies whose future earnings and fundamentals are anticipated to grow significantly faster than those of the overall market. A growth investor will typically rely more on qualitative information to make sense of the story. Technology stocks in the late 1990s and the Canadian cannabis sector in recent years are a good indication of the types of companies that attract growth investors’ interest.
General characteristics of growth investing:
- Less reliance on valuation ratios and more focus on past and prospective revenue and earnings growth rates, along with price momentum;
- Can be found in all sectors, but are typically associated with rapidly-changing sectors like Technology and Health Care;
- Holding period may be shorter, especially if the anticipated growth narrative changes;
- Expected to outperform in the later stages of a business/stock cycle, when investors are eager to fund new ideas; and
- Growth companies typically don’t pay a dividend; the business instead reinvests the money into its future growth.
Contrasting recent performance between the two styles
The Standard & Poors 500 (“S&P 500”) is a stock market index that consists of the 500 largest US-listed companies. Standard & Poors also splits the main index into the S&P 500 Growth and Value indices by classifying each stock as growth or value, based on many of the quantitative factors3 noted above. We use the S&P because it’s the world’s most recognizable stock index.
Given investors’ tendency to absorb new information, maybe it's appropriate that just as the value investing style really gained traction in the mid 1990s, the dot com/tech boom arrived and led growth stocks to significantly outperform value stocks for several years. The divergence was so wide that many at that time declared value investing was dead.
Just as the consensus grew that value investing no longer worked, it did very well over the next several years and protected capital as the tech bust rocked the markets. Value stocks further outperformed growth stocks as Financial companies expanded during the 2002-2007 [US] housing boom.
During the 2008 onset of the Global Financial Crisis, financial companies’ share prices declined drastically and many went bankrupt, while growth stocks outperformed. From the stock market bottom in early 2009 to the end of 2014 both styles were virtually tied, but growth has since pulled ahead significantly.
From 1995 to 2019, growth stocks (as defined by the S&P) have outperformed value stocks by roughly 1.5% annualized. What conclusions can be drawn from this?
Putting it all together
The appropriate question is not whether growth or value has outperformed in the past, but rather what certainty exists that either style will outperform in the future. If there is none or little such certainty, then the best solution is likely to hold the broad market index that spans both styles.
During the tech and telecom boom of the late 1990s, did anyone expect value stocks to outperform growth stocks for the next seven years? During the aftermath of the 2008 Global Financial Crisis, did anyone expect growth stocks to outperform value stocks for the next decade? The answer is quite likely no: just as market timing for individual stocks is difficult, timing between adopting a value or growth style is also very difficult.
The flood of articles over the past couple years postulating on the death of value investing is a timely reminder that an individual must be comfortable with their chosen investment strategy. For example, if an individual chose to be a value investor a decade ago because research indicated that it outperformed over the long run, how would they feel today after underperforming the broad market for 10 years? If the same individual switches strategies and moves to growth stocks, how will they feel if growth stocks underperform for several years?
The S&P 500 provides exposure to all stocks. It did not perform quite as well as growth stocks over the last 25 years, or quite as well as value stocks over the 25 years prior to that. However, because it was easy to stick with for the long term, the investors who held it likely did better than those who switched between styles, often at the very worst time. The goal shouldn’t be to guess which strategy will outperform, but rather to set and maintain an appropriate long-term strategy, one that also includes an appropriate asset mix (i.e. mix of stocks and bonds). Most importantly, it should be an investment strategy that can be adhered to for the long term. This is the path to investing success when it comes to style decisions.
Eugene F. Fama, and Kenneth R. French published The Cross-Section of Expected Stock Returns (June 1992), and Value Versus Growth: The International Evidence (August 1997).
James L. Davis published The Cross-Section of Realized Stock Returns: The Pre-COMPUSTAT Evidence (December 1994)
The methodology for index construction can be found in “S&P U.S. Style Indices Methodology”
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