There are few topics in the world of investment that will generate more spirited debate than the respective merits of the growth or value school of investing. Both schools of thought have their adherents and their pros and cons. Both growth and value investing have enjoyed periods where they enjoyed strong returns. And they have both endured periods where they have produced disappointing results.
What are the characteristics of growth and value investing? Is one approach better than another? Are there times when one should switch between the two investment philosophies?
Perhaps the most important observation to be made is that the performance of the value or growth investment styles is highly dependent on the economic and market environments.
Growth stocks began to significantly outperform value stocks from the start of the market low in March 2009 and the beginning of the long bull market of the past decade. This is in keeping with growth stocks’ tendency to outperform value in bull markets. There are many other examples, including the markets of the 1920s and late 1990s.
The reason that growth outperforms value in strong bull markets is that such markets tend to be driven by technological changes that produce a group of fast-growing companies related to the emerging technology. These growing companies become market leaders and accrue valuations that disqualify them from being considered value stocks.
The bull market of the past decade has been led by technology-related leaders such as Amazon, Facebook, Netflix, etc., which reflects the growth of online commerce. The bull market of the 1990s was propelled by the early internet stocks, while radio stocks were leaders of the strong markets of the 1920s. The great bull markets of the 19th century were the result of the building of canals and railroads, which opened North America for development.
Conversely, value stocks tend to outperform growth when economic conditions are more difficult. The golden age of value investing following the Crash of 1929 and the subsequent Great Depression. Business conditions were so difficult that many public companies cut spending and hoarded cash. Many stocks could be purchased near, or even below, the cash on their balance sheets with the rest of the business being had for free.
I had the opportunity while in business school to read through issues of Forbes magazine from about 1927 to 1955. The low stock valuations of the 1930s were astounding, with the famed father of value investing, Ben Graham, writing a series of articles in the ’30s exhorting companies to pay out their cash hoards as dividends to shareholders.
Value stocks had a second period of relative strength from about 1972 to 1982 when a combination of inflation and high interest rates put stock markets under severe pressure. Growth stocks cannot lead in such circumstances because the fuel needed to do so, revenue and/or earnings growth, is constrained by economic conditions. Value stocks tend to exhibit slower and more stable earnings growth patterns, along with more conservative valuations. Hence, they benefit from capital flows from investors seeking more defensive positions, which contribute to their typical outperformance versus growth during difficult times.
The inference for the years ahead is that whether value or growth stocks will be better performers will depend on the economic landscape. A return of inflation and/or interest rates to more normal levels may reduce real economic growth to an extent that allows value stocks to demonstrate market leadership.
The great advantage possessed by growth stocks is the accelerating pace of technological evolution that can be expected to continue. Evolving and new technologies can be counted on to produce a segment of fast-growing companies that will become market leaders that will likely allow growth stocks to outperform value in all but the weakest market environments in the future.
While matching an investment approach to the prevailing economic and market climate will produce the best results, it is even more important for an investor to adopt an approach that matches their personality. For example, a risk-averse investor would likely be better served to adopt the value approach because of its tendency to exhibit lower volatility over time than growth stock investing.
Taking the time to learn about each approach will likely prove to yield the best return to an investor.
Whatever approach one adopts, either growth or value, the long-term benefits will far outweigh an undisciplined, hit or miss method of investing.