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Growth vs. value investing

2021-02-28, Steve Porter

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Growth vs. value investing

Value investing and growth investing are two approaches for selecting stocks. Value investing is generally attributed to an approach used by Ben Graham and his apprentice Warren Buffett. They sifted through Moody's manuals and other reports to find companies trading below an estimated "intrinsic value." In some cases this resulted in purchasing poor or failing companies, if only because their assets exceeded their market cap. Growth investing originated in the 1960s with the so-called Nifty Fifty stocks. A different breed of investor bought these shares. The Nifty Fifty companies were growing so fast and seemed so invincible that a new breed of investor—growth investors—thought traditional value metrics couldn’t capture their worth.

This historical account may give a rough idea behind the two apporaches, but neither is well defined. In fact, many wiser investors don’t think there’s much of a distinction at all. In his year 2000 annual letter, Warren Buffett said “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.”

One problem is that there is no agreement on metrics. How should a value investor compute the “intrinsic value” of a stock? Without such an agreement, a stock can be labeled “value” by one person, but not another. Likewise for growth stocks.

Most value investors focus on the present value of a company's future cash flows, using the discounted cash flow (DCF) method. It’s a very logical way to estimate what a business is worth. The calculation is naturally boosted by growth, however. If a company’s cash flows are increasing sharply, then the present value of those cash flows will naturally be large. If the share price is low relative to this valuation, it’s a buy candidate for a “value investor,” using a “value approach.” Likewise, some value investors include patents, technology and other assets in their value metric—things often associated with growth companies. This is likely why some don’t believe in the contrast between value and growth—a growth stock can be a value stock. Here’s a related quote from Howard Marks.

“Value investing doesn’t have to be about low valuation metrics. Value can be found in many forms. The fact that a company grows rapidly, relies on intangibles such as technology for its success and/or has a high p/e ratio shouldn’t mean it can’t be invested in on the basis of intrinsic value.”

Not all growth stocks are value stocks, however. A company with rapid growth could be priced high relative to even the most optimistic estimate of “intrinsic value.” In this case we’d presumably label it’s stock as “growth” but not “value.” We call these stocks pure growth stocks. Such stocks may seem silly at first—who would want to purchase these “overpriced” stocks? However, these stocks have had periods of outperformance, including the Nifty Fifty in the 1960s and many stocks in the last decade (Tesla has returned ~400% in the last year!). Indeed “momentum investing”—buying stocks that have recently outperformed the market—has been very successful lately, despite often leading to the purchase of relatively "expensive" stocks. Famous momentum investor Richard Dreiehaus said more money could be made “buying high and selling higher” than buying low and selling high. (For the record, I don't like this approach.)

On the flip side, consider a stock labeled as value but not growth. Let’s say this company has had very consistent earnings for years or decades and will likely continue to. DCF calculations reveal that shares are substantially underpriced relative to intrinsic value. We’ll refer to such stocks as pure value stocks. If a “growth investor” spotted a pure value stock, would she / he not buy it? Why? Just because they want to adhere to a growth strategy?

The latter question may explain why Charlie Munger once said “all investing is value investing” and Warren Buffett has stated that “value investing” is a redundant phrase. However, people do buy pure growth stocks, sometimes with wild success (especially recently). So this is a rare case where I’d disagree with Warren and Charlie.

What do we want our readers to know about value and growth investing?

  • Historically speaking, the better-performing option has depended on the market cycle: value stocks do better in bear markets, while growth stocks perform better in bull markets.
  • Most long term studies have shown that value stocks perform better over the long haul. This study reported that, from 1990 to 2014 (25 years), value stocks slightly outperformed growth stocks. This was true for small, mid and large cap stocks, but most significantly for small caps. A Bank of America study claimed that, from 1926 to 2020 value stocks returned 1,334,600% while growth stocks returned just 626,600%.
  • No one can tell you what you probably really want to know—which style will be more successful in your investing lifespan. Although value stocks have done better historically, it's not obvious this will continue. For one, it's become easier (and will continue to) to access data and estimate intrinsic values. Hence, the low-hanging fruit value investors benefited from is vanishing. There are other reasons as well, we recommend Howard Marks' 2020 memo for more discussion on this topic.
  • Over the last decade growth stocks have substantially outperformed value stocks, leading some to conclude that value investing is dead. However, many experts think value stocks will outperform growth in the coming decade, particularly in the next recession or when interest rates rise (see this study for more information).
  • Growth stocks can be volatile and are better suited for risk-tolerant investors with a long time horizon. The value of growth stocks relies heavily on yet unrealized growth, which may not bear fruit.
  • Growth stocks typically do not pay dividends. These companies prefer to reinvest earnings to expand the company. If successful, this is great for investors. However, if the money is not well spent you lose your dividend and likely some principal too, a double negative.

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