Growth or Value Investing -- The Style that Works the Best?
March 22, 2012
To buy growth or value stock is a question that has been debated among those that have steadfastly practiced either style of investing for as long as the stock market has been acknowledged!
Growth investors buy stocks of companies whose businesses are growing rapidly. Examples of these that come to the fore are Microsoft (Nasdaq: MSFT) in the 1990s, or a company like Verifone (NYSE: PAY) today, which makes technology for electronic payments -- everything from credit card readers to new technology that will allow you to pay for goods and services simply by swiping your phone next to a reader. Verifone’s earnings per share are predicted to grow by 24% per year over the next five years.
Therefore, to define "Growth Stock”, is simply shares in a company whose earnings are expected to grow at an above-average rate relative to the market.
These are also known as a "glamour stock".
A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects. Most technology companies are growth stocks.
Note that a growth company's stock is not always classified as growth stock. In fact, a growth company's stock is often overvalued.
Whereas, looking at the argument from the side of the value investors, who believes, that while growth is nice, you must be sure you’re buying the stocks at a discount.
There were a lot of good value stocks after the financial crisis, with companies trading at extremely low valuations. An example of a value company is TD Ameritrade (NYSE: AMTD) – which, in 2009, at the depths of the financial crisis, the stock traded at less than 8 times trailing earnings.
Its five year average P/E ratio is 15. Today, even though earnings per share are actually lower than they were in 2008 and have been relatively flat over the past few years, the stock is back at its five year average P/E of 15.
Value investors love market downturns, because they view them as opportunities to buy great companies cheap.
Therefore, the definition of ”Value Stock” simply means a stock that tends to trade at a lower price relative to its fundamentals (i.e. dividends, earnings, sales, etc.) and thus considered undervalued by a value investor. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio.
A value investor believes that the market isn't always efficient and that it's possible to find companies trading for less than they are worth. An easy way to attempt to find value stocks is to use the "Dogs of the Dow" investing strategy - buying of the 10 highest dividend-yielding stocks on the Dow Jones at the beginning of each year and adjusting it every year thereafter.
The strategy was formulated in 1972 and has proven to be successful. In fact, as Dog of the Dow investors readjusts their portfolios each year, it places pressure on the stocks involved.
Price Differences for Growth or Value Investors
Both types of investors want to buy great companies. The main difference between growth or value investors is the price they’re willing to pay for them. Growth investors will pay more for a company if its growth prospects are strong, assuming that the stock price reflects its growth potential. Value investors certainly want growth, but are willing to settle for slower growth as long as the stock is trading at a discount. A value investor will be happy to own a mature company like General Electric (NYSE: GE) or Intel (Nasdaq: INTC), whose strongest growth days are behind it -- if the price is right.
The Style that Works the Best – Growth or Value Investing?
There are various studies available that will show that growth or value stock work better over various time frames.
Therefore, it is interesting to see which style has worked better, by pursuing a different method of study based on several different time periods and holding periods.
The growth stocks that are used in this study were companies that grew earnings 17% or more in the previous year, and the five year growth rate was expected to be 17% or higher. Value stocks that are used were classified as profitable companies with P/E ratios of 12 or lower (the current P/E of the S&P 500 is 15).
'Price-Earnings Ratio - P/E Ratio' is a valuation ratio of a company's current share price compared to its per-share earnings.
For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).
EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.
Also sometimes known as "price multiple" or "earnings multiple".
Results from the Study between Growth or Value Stock!
As you can see from the chart below, value stocks beat growth stocks in every period except for over the past five years. Over a ten year period the difference was substantial. Stocks were held for one year, after which the study was run again and stocks that no longer qualified were sold and new ones were bought.
The results were similar over different holding periods for growth and value stocks.
It makes sense when you think about the ten year results, as it captures part of the dot com bust and the entire financial crisis. Therefore, it is not surprising that value stocks fared better. It is also surprising that they outperformed over three years, as it should be assumed that once the 2009 bull market started, growth stocks would have outperformed value – however, this did not eventuate.
But looking at some of the names that made the value list, it makes sense. Companies like Stone Energy Corp. (NYSE: SGY) that was absolutely crushed during the crisis, falling from over $70 a share to under $2.
Carnival (NYSE: CUK) was another that took a plunge. It earned $2.90 in 2008, yet when the market bottomed in 2009, the stock traded at just 5 times earnings. Despite the fact that earnings haven’t been that high since -- and are not likely to be better this year after two disasters -- the stock is now trading at 12 times earnings.
Oddly, over the past year, both growth and value stocks (the way defined in the study) have been negative, despite a 4% rise in the S&P 500.
Conclusion of Growth or Value Investing
If sales growth is included in the growth study, or price-to-book value in the value study, the results might be different. But on the surface, it appears that value has been the way to go both recently and over the past decade -- only coming off the bottom of three years ago did growth outperform.
Even in 2002, when the markets were still seven months from the bottom, being invested in value stocks seems to have offered some protection from the remainder of the bear market.
Value seems to be what’s working now. But keep your eyes open for a shift towards growth as favored investing styles don’t stay that way forever. They very often change places, and you want to be ready to catch the move.
Be flexible -- follow the growth or value trend to profit!