A Look At Value And Growth Stocks
Generally speaking, two terms are commonly used to describe the two main styles of investing, growth and value investing.
Some investors may purchase only value stocks while others may buy only growth stocks, the two styles of investing are not mutually exclusive. There are also investors who buy both types of stocks for their portfolio.
Now, that being said, you still might wonder with two choices being available, which stocks tend to perform better than the other, value or growth?
This question is natural. Why would any rational person knowingly choose an investment method that is less efficient?
Sure. Someone may choose a different method because it feels better to them, or because they like it, but those are emotional, not entirely rational decisions.
Let’s take a closer look and see what the academic research says.
Value And Growth Defined
Growth stocks are those which have earnings that are expected to grow at a rate faster than the rest of the stock market as a whole. They are commonly found in exciting or new industries.
More often than not, growth stocks are popular with investors, and so their prices have been bid up to nosebleed levels. As growth stocks tend to be expensive, they are prone to come crashing down hard.
Value stocks are stocks which, at least temporarily, trade at a stock market price that is lower than they should be fundamentally trading. Usually, value stocks are in boring or unpopular industries.
Value stocks may also have disappointed investors recently which has caused their stock prices to drop. Due to their unpopularity, it may take value stocks quite some time for their stock prices to rise.
It is important not to get too caught up in the differences between these two broad categories of stocks.
Value investors certainly like growth. They just like growth at a reasonable price. Growth investors also prefer to buy stocks with fast-growing earnings at lower prices whenever possible.
Lou Simpson, who was formerly at Berkshire Hathaway and now runs SQ Advisors, explains:
“When you ask whether someone is a value or growth investor – they’re joined at the hip. A value investor can be a growth investor because you’re buying something that has above-average growth prospects and you’re buying it at a discount to the economic value of the business.”
During a keynote speech titled Trying Too Hard at the Financial Analysts Federation Seminar at Rockford College on August 9th, 1981, Dean Williams of Batterymarch Financial Management made an astute comment:
“There is no such thing as a growth stock. Only passing phases of growth in almost every company’s life. Phases whose beginning and end usually appear in disguise.”
Warren Buffett, arguably one of the best investors and world’s richest men, has stated:
“Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication.”
Likewise, Charlie Munger, Warren Buffett’s right-hand man at Berkshire Hathaway who is known for speaking his mind, had this to say on the subject:
“The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle. It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one advisor to distinguish himself from another. But, to me, all intelligent investing is value investing.”
Taking a look at the academic research on the topic, in a paper titled Ibbotson Style Indices: A Comprehensive Set Of Growth And Value Data, Ibbotson Associates found that during the period that they studied, 1969 to 2002, value stocks outperformed growth stocks.
Now, one study by itself should always be taken with a grain of salt. It is always preferable to see if other studies by other researchers arrive at similar results.
Using data from 1980 to 2014, in research published by The Brandes Institute titled Value Vs. Glamour: A Long-Term Worldwide Perspective, the authors found similar results. Again, over the period measured, value stocks did indeed outperform growth stocks.
Likewise in a blog post titled Comparing The Results Of Value And Growth Stock Market Indexes by Wiley Global Finance, which summarized the research of Craig L. Israelsen in the book 7Tweleve: A Diversified Investment Portfolio With A Plan, between the years 1980 to 2010, again value stocks performed better than growth stocks.
Unlike some other investment strategies which only work for a short period and then stop working, value stocks have continued to outperform over the long-haul.
Now, no style of investment works all of the time.
Although value investing has continued to outperform over the long term, there have also been periods of temporary underperformance relative to growth strategies.
Value Underperforms In Late-Stage Bull Markets
Value stocks tend to outperform the rest of the stock market during the later phases of bear markets and even during the early and middle stages of bull markets.
However, in the late stage of a bull market, value stocks do tend to underperform when compared to indexes and growth stocks.
On page 12 of the book Charlie Munger: The Complete Investor, Tren Griffin had this to say on the subject:
“The Graham value investing system is intentionally designed to underperform an index in a bull market; this is confusing to many people. The underperformance of the Graham value investing system during a bull market is an essential part of this style of investing. By giving up some of the upside in a bull market, the Graham value investor is able to outperform when the market is flat or down.”
This tendency of value stocks to underperform during late bull markets makes complete sense, in that Benjamin Graham, who is known as the father of value investing, had lived through the depression and so his investing style focused on the preservation of capital.
Avoidance Of Runaway Hype
While many, especially talking heads on financial TV with a myopic view, may be quick to criticize the short-term underperformance of value stocks during the last stage of bull markets, missing out on some “gains” may be preferable. Value investor Seth Klarman explains:
“Occasionally we are asked whether it would make sense to modify our investment strategy to perform better in today’s financial climate. Our answer, as you might guess, is: No! It would be easy for us to capitulate to the runaway bull market in growth and technology stocks. And foolhardy. And irresponsible. And unconscionable. It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it. Yet distancing yourself from the crowd is an essential component of long-term investment success.”
Jean-Marie Eveillard, the French value investor and senior investment adviser to First Eagle Funds, also wrote about this subject:
“We refuse to participate in the last few years of a long bull market because those last few years are when you get a speculative bubble.”
Certainly, if the stock market is overheated and stock prices have been bid up by investors due to hype alone, then those price increases do not accurately reflect the actual values of those companies. Sooner or later, those stock prices will come crashing down once investors finally come to their senses.
Sooner or later, those stock prices will come crashing down once investors finally come to their senses.
Market Timing Is Impossible
You might think that is an investment strategy is underperforming then it is best just to change strategies quickly. However, like most things in life, it is never that simple.
No one knows what the future will bring. It is easy to look at a 10-year chart for a stock and say “I would have bought here and sold there.” However, in real life with the financial media magnifying good and bad news to improve ratings, it is a lot harder to make wise investment choices.
For example, if you suspected that value stocks were going to underperform and that growth stocks were going to outperform in the near future, then you would sell your value stocks and buy growth stocks.
However, the timing is tough. You would have to sell and buy at exactly the right time to make that strategy work. Then again, you might be wrong, and value stocks might continue to outperform the growth stocks.
As always, even though changing investment strategies might look tempting on paper, once you sit down and figure out the trading fees, loss on the bid/ask spread, and taxes that would have to be paid, the change in investment strategy is rarely, if ever, profitable.
Aren’t Value Stocks Riskier?
Now one might assume a stock that has recently fallen in price is riskier than a stock that has recently risen. However, that is not necessarily the case.
Joel Greenblatt, an adjunct professor at Columbia University and author of The Little Book That Beats The Market and You Can Be A Stock Market Genius: Uncover The Secret Hiding Places of Stock Market Profits, explains:
“A stock that has fallen from 30 to 10 is considered riskier than a stock that has fallen from 12 to 10 in the same period. It might be. But it could be that most of the stock’s downside risk has been eliminated by the huge price drop. The truth is you can’t really tell much of anything just from measuring a stock’s past price movements.”
Warren Buffett concurs. When referring to stocks that have dropped in price below their intrinsic value, Warren Buffett stated:
“It’s not risky to buy securities at a fraction of what they’re worth.”
Research by Roger Ibbotson, emeritus professor of the practice of finance at Yale University, found this to be true. When discussing his research on why value stocks outperform growth stocks and whether that was caused by taking on additional risk stated:
“The value premium isn’t necessarily a risk premium. It has always been called a risk premium, but if you look at risk, it turns out that that growth has bigger risk.”
He later went on to summarize the relationship between the two:
“In practice, value beats growth, but with slightly less risk.”
I try to take the most logical approach to investing. It certainly isn’t easy.
I experience just as much self-doubt when my stocks underperform, jealousy when seeing someone else has better stock market returns, and fear if I listen too much to talking heads on TV.
I also notice that I have a tendency to feel more confident that the price of a stock will continue to rise if it has recently risen in the past. Likewise, buying value stocks is often uncomfortable as their stock prices are more likely to have recently fallen. I don’t believe I’m the only one to feel that way.
Still, I regularly try to force myself out of my comfort zone. It is a constant battle, but I try to override my desires and feelings to make rational investment decisions.
In my portfolio, despite some initial discomfort, and much like the academic research has shown, I have noticed that value stocks have outperformed growth stocks and with less risk. The growth stocks I purchased were more prone to significant drops in share price and less likely to recover.
Which Outperform: Value Or Growth Stocks?
The academic research is clear. Value stocks outperform growth stocks over the long term.
Stocks that are purchased at a discount to their intrinsic value show a persistent outperformance over those with faster-growing earnings over the long term. Moreover, value stocks do so with lower risk.
I’ve also noticed the outperformance of value stocks in my stock portfolio. Incidentally, I would be remiss if I did not add that many of the most successful investors, like Warren Buffett, have also been value investors.
If you want to improve your investment returns, consider buying some value stocks. Despite tending to be less glamorous than growth stocks, the odds of success with value stocks will be in your favor.
Numerous academic studies has proven that value stocks outperform growth stocks.
Value stocks temporarily underperform during speculative bull markets.
Value stocks are less risky than growth stocks.
Value Vs. Glamour: A Long-Term Worldwide Perspective (PDF)
Ibbotson Style Indices: A Comprehensive Set Of Growth And Value Data (PDF)
Can You Get Higher Returns From Low-Risk Stocks? (Video)
Value Or Growth Stocks: Which Is Best?
Comparing The Results Of Value And Growth Stock Market Indexes
Value Strategies Almost Always Outperform Growth Strategies
The Growth And Value Pendulum
Charlie Munger: The Complete Investor. By Tren Griffin. Page 12.
Trying Too Hard. (PDF) Keynote speech at the Financial Analysts Federation Seminar at Rockford College on August 9th, 1981 by Dean Williams of Batterymarch Financial Management.
The Case For Sticking With Value Stocks