The chart below shows that growth stocks (orange line) outperformed value stocks (purple line) by three-fold from 2010 through late 2020. Then came the vaccine announcement, which ignited a violent reversal of this trend. Stocks that had languished for most of 2020 over legitimate fears that many companies would not survive staged an impressive comeback.
This shift fueled rampant speculation that the tide finally turned for value investors. Their day in the sun has finally arrived, and the greedy growth investors who’ve ignore valuation for so long are getting what they deserve. Growth investors dismiss such claims. They remain convinced that the sellers earlier in the year will come running back in due time.
The debate between growth and value investing is nothing new, but it appears to have intensified lately. Before picking a side, let’s first discuss the differences between the two investing styles and the pros and cons of each.
Highflyers
Growth stocks represent companies that are expected to deliver better than average gains in revenue and/or earnings through good and bad times. This is where much of the excitement in the stock market can be found because these stocks get the most press, mint millionaires, and award bragging rights at holiday dinners.
For example, Amazon has remained one of the highest profile growth stocks for over two decades. Investing $10,000 when Amazon went public would be worth a staggering $17.2 million today1. It’s hard to even quantify this type of wealth creation, but it’s pretty easy to understand why so few investors have benefitted from it.
To start, owning growth stocks requires strong conviction and an even stronger stomach. These stocks tend to be more expensive and exhibit more volatility than the broader stock market. High-flying growth stocks are often priced for perfection, so even the slightest bit of negative news can clip wings.
The chart below shows that even Amazon hasn’t been immune to volatility. Its stock fell over 90% in the early 2000s and took eight years to recover (only to get whacked by over 60% months later). The dotted line also shows that long-term investors have endured regular drawdowns that averaged over 25%. This type of volatility will test the resolve of even the most devoted believer.
But arguably the biggest challenge with growth stocks is finding them. Sure, it’s obvious today that Amazon is one of the largest and most successful retailers of all time, but all they sold back in the late 1990s was books. Furthermore, for every Amazon, there’s been countless duds that have experienced permanent declines. That’s why picking growth stocks is such a high risk, high return business.
It’s Intrinsic
Investors tend to overreact to bad news, so the idea behind value investing is to look for companies with strong fundamentals that have fallen out of favor. Value stocks are also perceived to be less risky since their prices tend to be below the broader market. The thinking is that these stocks have already been hit, so there’s not much more damage that can be done.
Although value stocks may not get as much media attention, strategies that focus on slower growth and more mature stocks have their place. For example, value stocks often pay attractive dividends, which have played a significant role in equity returns over the past 50 years. In fact, approximately 84% of the total return of the S&P 500 Index can be attributed to reinvested dividends and compounding2.
Source: https://www.hartfordfunds.com/market-perspectives/the-power-of-dividends.html |
Furthermore, the chart below shows the performance of S&P 500 companies from 1973 through 2020, segmented by dividend payment policy. The two best performing strategies were those with a focus on dividends.
The allure of value investing is that it’s based on a formulaic process that can theoretically be repeated. It’s less abstract and more concrete than the nebulous world of growth investing. Buy a stock whose “intrinsic value” is worth more than what its current price suggests, wait for the market to realize this value, and then ring the register as you get one step closer to becoming the next Warren Buffett.
It sounds too good to be true because it is. To start, calculating the “intrinsic value” of a company is borderline impossible and highly subjective. My assessment of the risk of future cash flows for a company could vary greatly from someone else’s.
Furthermore, there are a lot of stocks that are cheap for a reason. These are called “value traps” because they screen cheap but don’t have the fundamentals to rebound over time. Knowing the difference between a value stock and a value trap is a skill that even some of the most successful investors regularly screw up.
Lastly, the fame and fortune of Buffett and other notable value investors have attracted significant competition to the arena. With this many proficient investors running strategies based on the same curriculum taught in nearly every business school, it’s become a lot harder to find value in the market today relative to decades ago.
The Bottom Line
In the pantheon of useless financial debates, I’d give “growth vs. value” the silver medal. It’s never made any sense to me why both sides treat this rivalry like Ohio State vs. Michigan. Investing is about risking capital today to achieve future goals. Since there’s more than one goal out there, both styles have their place.
It’s no different than comparing a minivan to a sports car. If the goal is getting somewhere fast, then the sports car is a no brainer. But if the goal is moving from one apartment to another, that minivan is going to get the job done faster and with less damage. Debating which is better without first defining the goal makes no sense.
That’s why when I get asked if I am a growth or value investor, my answer is always the same. I say I’m a goals-based investor. Tell me your goal and I’ll do my best to get you there using the right tools for the job.
Sources
1 Bloomberg, as of 8/5/2021
2 https://www.hartfordfunds.com/insights/market-perspectives/fixed-income/the-power-of-dividends.html
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. Richard W. Paul & Associates does not provide tax, legal, investment, or accounting advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.