Which means higher returns, growth stocks or value investing, for your portfolio?
Anyone with money in the stock market for more than a couple of decades has heard of the value premium, the idea that value investing beats growth stocks.
The history of returns for value versus growth investing is so strong, it’s almost a stock market rule.
It makes sense, right?
Stocks are an investment in the future cash flow of a company. Paying less for those future cash flows as in value stocks should mean you earn a higher return.
Well, rules were made to be broken and the last decade has seen a shift in the growth versus value investing debate. Growth stocks are now offering higher returns.
What does this mean for the average investor? Should you invest in high-flying growth stocks like Amazon, Facebook, Netflix and Tesla or should you stick with the value investments and hope the long-term trend returns?
What is Value Investing?
Value investing is buying stocks that are relatively less expensive than others in the same industry or sector. The most common measure of this is the stock’s price-to-earnings ratio or its price relative to sales, book value of assets or cash flows.
There is no cutoff or definite point for what is a value stock. Many investors look for stocks with a price no more than 10- or 15-times the company’s previous year’s earnings.
Value investing makes intuitive sense for many investors. Why pay so much for a company’s expected future earnings if you can get a ‘better’ deal?
There are some important things to remember about picking value stocks.
- The term ‘relative value’ is very important. If one company is priced at 15-times its last year’s per share earnings and another is trading for 20-times earnings, the only thing you can say for sure is that the first company is priced less expensively compared to the second. It doesn’t tell you that it is a good investment. Both stocks may be expensive or cheap.
- Always compare a stock’s valuation measures against other stocks in the same industry or sector. Some industries or sectors typically have lower valuations than others. Stocks of telecom companies trade for much lower valuations because earnings growth is much lower than other sectors. Conversely, most technology stocks trade for higher values because the sector enjoys faster growth. Blindly comparing telecom stocks against tech stocks would make all the telecom stocks look like great values and all the tech stocks look expensive.
What is Growth Investing?
Growth stocks are just the opposite. Companies classified as growth stocks typically have very high price-to-earnings values because earnings growth is much faster. Investors are willing to pay a higher price for each dollar of earnings because they believe those earnings will continue to grow quickly in the future.
Just as with trying to define value stocks, there’s no clear cutoff for what is a growth stock. Most investors go by the idea that if it’s not a value stock then it’s growth, i.e. if the average price-to-earnings ratio for stocks in a sector is 15-times then those stocks trading for much higher (say 25-times and above) must be growth stocks.
Growth investing isn’t totally ridiculous. Yes, investors pay more for the company’s previously reported earnings but it’s expected that profits are going to grow quickly. Shares of Netflix trade for an astounding 217-times earnings reported to Q1 2017 but analysts expect the company to grow those earnings by nearly 45% over the next year.
If Netflix continues to grow its sales and earnings, current investors may be proven right with a stock price that keeps going higher.
Which is the Better Investment, Value or Growth Stocks?
Value investing has historically paid off as the better investment, so much so that the idea of a ‘value premium’ is well known among investors.
Nobel laureates Fama and French first identified the value premium in 1992, comparing returns on high book-to-market value stocks against low book-to-market stocks. It’s one of the three factors in their asset pricing model to explain excess returns in a portfolio.
The graph compares the total return on stocks in the Russell 1000 Value Index versus those in the Russell 1000 Growth Index for the 28 years through 2008.
Even after the stock market crash, an investor in the value stocks would have seen their money grow more than 20-fold over the three decades. A $10,000 investment in value stocks in 1980 would have grown to nearly $220,000 compared to just $125,000 for someone investing in the growth stocks.
Not only did value stocks earn higher returns but they also did it with less risk over the time period. Value stocks saw their prices move up or down by an average of 16% annually over the 28-years versus volatility of 21% for stocks in the growth index.
But something has happened to the value premium and the idea that value investing beats growth.
Since 2008, growth investing has outperformed.
A $10,000 investment in the growth stocks index would have grown to $35,600 over the last eight years, well above the $27,000 you would have earned in a value investing portfolio.
The main reason for the change in value investing versus growth has been super-low interest rates over the past decade. The Federal Reserve and other monetary authorities around the world lowered interest rates in response to the financial crisis and kept them there for a very long time.
With access to loans at such low rates, companies were able to borrow cheaply to increase profits quickly. They bought back their own shares which also boosted per-share earnings and made profit growth look even faster.
That doesn’t mean growth investing will continue to outperform versus value investing. The Federal Reserve is raising interest rates and the European Central Bank has ruled out further rate cuts. After eight years of economic growth, companies may find it harder to boost earnings as quickly.
That could bring back value investing to beat growth stocks.
Should You Invest in Value Stocks or Growth?
I don’t usually promote investing strategies or stock picking on the blog but the value investing versus growth debate is so popular, I thought I should address it. The reversal in returns is also interesting and says something about the stock market and the economy over the last decade.
But does it matter for the average investor?
Should you worry about getting an extra percent or two return by investing in growth versus value or vice-versa…or is it better to just pick a broad portfolio of stocks that matches the overall market return?
Investing is personal and you have to make your own decision based on your financial goals. I like using a stress-free investing strategy where I invest the majority of my money in broad-based index funds and the rest in more focused funds and individual stocks. This gives me exposure to the larger market and market returns while still enjoying the potential for higher returns on good investments.
I happen to believe that the value premium will return as interest rates increase and economic growth slows down. That means I’ve put a little more of my money in value investing funds and individual stocks with lower price-to-earnings ratios.
I’ve included the next two sections as a brief overview of how to find growth or value stocks.
How to Find Value Stocks
Finding value stocks is simply comparing the price relative to a measure of sales or profits versus other stocks in the sector.
Most investing platforms offer a stock screener allowing you to sort by price-multiples. I like the stock screener on TD Ameritrade for its ease of use and the platform is one of the least expensive for investors.
- Remember to run separate screens for each sector so you are comparing valuations in related companies
- I like to search for stocks with P/E values well under the industry average
- I’m a big believer in dividend stocks and also screen for companies that are paying out at least a 2% yield
- Further screen for positive sales growth and a return on equity higher than the sector average
This isn’t a fool-proof way to pick value stocks but will get you started with a list of 10 potential investments in each sector. From there, you can read analyst reports and look deeper at each company’s fundamentals.
Pay special attention to debt the company has relative to its equity and cash flow. Some value stocks are cheap for a reason, i.e. investors are worried about the company’s ability to repay debt.
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How to Find Growth Stocks
Finding growth stocks is not quite as straight forward as picking value stocks. You’ll start with the same stock screener but might consider the following criteria:
- Revenue growth above the sector or industry average
- Earnings growth above the sector or industry average
- Most growth stocks do not pay much of a dividend yield. They are busy putting profits back into the business to pay it out to investors. I still like to see some dividend, maybe a percent or two.
Separate analysis is even more important when picking growth stocks because you need to see that earnings growth will continue into the future. Be wary of companies that have grown quickly as a result of an acquisition strategy. They will need to continue to buy other companies to keep up the growth investors expect and may run into a debt problem.
The debate about value versus growth investing rages on and nobody really knows if the value premium will come back to the markets. Investing in value stocks offers some protection against stock market crises so it’s a good way to protect your nest egg. Growth stocks offer the potential for higher returns but a lot more risk as well.
