When is the best time to use each one?
In the world of investing, there are few topics that spark a livelier debate than the merits of investing in either the growth or value school of investing. Both schools of thought have their adherents and their advantages and disadvantages. Both growth and value investing have seen periods of strong returns. And both have gone through periods of disappointing results.
What are the characteristics of growth and value investing? Is One Approach Better Than Another? Are there times when you should switch between the two investment philosophies?
Perhaps the most important observation is that the performance of value or growth investing styles is highly dependent on the economic and market environment.
Growth stocks have clearly outperformed value stocks since the market bottomed out in March 2009 and the start of the long bull market of the past decade. This is in line with the tendency for growth stocks to outperform in bull markets. There are many other examples including the markets of the 1920s and late 1990s.
The reason that growth outperforms in strong bull markets is because those markets tend to be driven by technological changes that create a group of fast growing companies related to emerging technology. These growing companies become market leaders and receive ratings that deter them from being considered worth stocks.
The bull market for the past decade has been led by technology leaders like Amazon, Facebook, Netflix, etc., reflecting the growth in online trading. The bull market of the 1990s was driven by the early Internet stocks, while the radio stocks led the strong markets of the 1920s. The great bull markets of the 19th century were the result of the construction of canals and railways that opened North America to development.
Conversely, value stocks tend to outperform when economic conditions are tough. The golden age of value investing after the crash of 1929 and the subsequent Great Depression. Business conditions were so difficult that many public corporations cut spending and hoarded cash. Many stocks could be bought near or even below the cash on their balance sheets, with the rest of the deal being available for free.
During my time in business school, I had the opportunity to read through Forbes magazine from about 1927 to 1955. The low stock valuations of the 1930s were astonishing when the famous father of value investing, Ben Graham, wrote a series of articles in the magazine. 1930s admonish companies to pay out their cash reserves to shareholders as dividends.
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 required to generate sales and / or earnings growth is limited by economic conditions. Value stocks tend to have slower and more stable earnings growth patterns as well as more conservative valuations. Hence, they benefit from capital flows from investors seeking more defensive positions, which contributes to their typical outperformance over growth in difficult times.
The conclusion for the years to come is that it depends on the economic landscape whether value or growth stocks perform better. A return of inflation and / or interest rates to more normal levels can slow real economic growth to an extent that allows value stocks to demonstrate leadership.
The big advantage of growth stocks is the accelerated pace of technological development, which is expected to continue. Developing and emerging technology can be counted on to produce a segment of fast-growing companies that will become market leaders and likely enable growth stocks to outperform in all but the weakest future market environments.
While customizing an investment approach to suit the prevailing economic and market climate will produce the best results, it is even more important for an investor to choose an approach that suits their personality. For example, a risk averse investor would likely be better placed to adopt the valuation approach as it tends to be less volatile over time than an investment in growth stocks.
Taking the time to familiarize yourself with each of these approaches is likely to produce the best return for an investor.
Whichever approach you take, either growth or value, the long-term benefits far outweigh an undisciplined, successful, or missed investment practice.