There is an old saying for musicians and bands that you are either like The Beatles or The Rolling Stones. This “one-or-the-other” philosophy has formed strong beliefs towards how music should be written, recorded, and played.
There are two investment styles in the finance world which closely mirror the “Beatles or Rolling Stones” philosophy. In finance you are either a value investor or a growth investor.
But the questions I would like to answer are: Which is the better investment strategy? Which style produces the superior results? And which style should I use to invest my money?
Before we start to answer these questions, I want to give a brief background of both strategies. I will try to define what each of the strategies entail and some academic research which supports each method.
The basic principle that divides value investing from growth investing is what is known as price multiples. Price multiples include ratios such as price-per-earnings (P/E), price-per-cash flow (P/CF), price-per-book value (P/BV), price-per-sales (P/S) and many other ratios that describe the stock using the current market price of the stock.
This kind of ratio analysis allows you to get a relative comparison across different industries and companies. By far the most frequently used price multiple is price-per-earnings (P/E). This price multiple is very simple and only requires two numbers to compute. The numerator is the current market price of the stock and the denominator is the most resent figure for earnings, usually the last four quarters or year-end amounts.
Just about every financial website offers P/E ratios as part of their summary info on stocks. This makes the P/E a very easy and accessible tool for investors to base their investment strategy or decision around. Some would argue that this ratio is what determines if a stock is considered value or growth.
If you are new to stock markets, it may be useful to explain how stocks are priced. It seems reasonable to assume that stocks are based on the value of the company, that being the value of all their assets (what they own) minus their liabilities (what they owe). After all, if you were to calculate what you are worth you would add up all your assets and subtract all your liabilities. But there is a big difference between a business’ worth and an individual’s worth; a business creates an income stream or a cash flow.
The stock market favors companies that produce a higher income stream, but what is even more sought after is an income stream that has high growth.
Think of it this way. You have two companies: company A and Company B. Both these companies are in the same industry and face relatively the same risks. Both companies are public companies and trade on a stock exchange. Both company A and B sell for $20 a share at the moment and both have a current earnings per share (EPS) of $1.00. The only difference is that company A is expected to grow their earnings by 5% per year and company B is expected to grow at 10% per year. Which company would you rather buy? If you said company B then you probably have graduated from the school of common sense.
For the same amount of money ($20) you can buy company B, whose earnings are estimated to be about $2.59 in ten years compared to company A whose earnings are estimated to be around $1.63 in the same time period.
In a real stock market you would rarely see these two companies selling for the same price because investors favor growth. Company B would sell at a higher price than company A because of the greater expected growth.
And that in a nutshell is how value stocks and growth stocks are separated.
Value stocks are those stocks that tend to have low price multiples. The P/E for these stocks tends to be in the low teens or single digits. They are called value stocks because they are cheap relative to other stocks in the market.
As of writing this article, some stocks that would be considered value stocks include: Exxon Mobil (P/E = 9.22), JP Morgan Chase & Co. (P/E = 8.87), and Cisco Systems Inc. (P/E = 12.91). As you can see from these examples, value stocks are not limited to certain sectors (although some sectors do tend to be heavier weighted in value stocks).
Value stocks have less to do with what the company does and more to do with analysts’ predictions about the company.
The idea behind value investing is that these particular stocks are out of favor in the eyes of investors for some reason. It could be because of bad news surrounding the company, a poor outlook from analysts, the industry has become mature and future growth id limited, or not meeting prior expectations for earnings by analysts. Value investors believe that these situations are short-term and that if the company has sound economics, then the prices of the stocks should revert back to the norm.
This “reverting back to the norm” may take some time. It may even take years. That is why most value investors are also long-term investors or buy-and-hold investors. The average investment period for these investors would probably be around 5 years. If the news surrounding the company is pretty significant, it could take a long time for people to forget about it. Or if new management comes in to improve operations, it could take a couple years before you start to see results. This is why value investors hold their securities for the long-term and in some cases indefinitely (or until their goal is met such as retirement).
Growth (Momentum) Stocks
The polar opposite of value investing is what is known as growth investing, or what might be familiarly known as momentum investing.
Momentum investing uses high P/E ratios as an investment strategy. These multiples can be in the high teens and reach as far as in the forties and fifties. These stocks are relatively more expensive than other stocks in the market. This is because these stocks are expected to have superior growth.
High P/E stocks are what would be known as “hot stocks”. These are stocks that are currently creating a buzz in the investment world. Because analysts and investors are showing so much interest in these stocks, they are purchased more and their stock prices start to rise as a result.
These stocks tend to be new ventures or high-tech companies, but can include any company whose price has been pushed up greatly because of large expected growth.
As of this writing, some growth stocks include: AT&T Inc. (P/E = 48.70), Whole Foods Market Inc. (P/E = 40.86), and IMAX Corp. (P/E = 51.52). As you can see, some of these companies are in high-tech industries, but others are not. Whole Foods is not high tech, but it is a stock that is tied to a hot trend (organic grocery) that is expected produce growth in the future, so the stock price reflects that growth potential.
The theory behind momentum investing is that companies whose stock price have done well in the past few months (usually past six months) will continue to do well in the near future because of the “momentum” effect of other investor joining in to get in on the action. The hope is that a stock may be purchased at a P/E of say 30 and sell when it reaches maybe 35, 40, or 50.
Now momentum trading should not be confused with day trading. Day traders will hold a stock for hours or even minutes, whereas a momentum trader will hold a security for six to eighteen months on average. They are still in some sense buy-and-hold investors, but their time frame is really the short-term compared to value investing. Their strategy may include chart patterns and quantitative analysis like day trading, but it does not have to.
Compare and Contrast
So from the above we can make a few simple distinctions between the two investment styles.
- Value Investing
- Long time horizon
- Low price multiples (low P/E)
- Out of favor stocks
- Low or average growth potential
- Growth (Momentum) Investing
- Short time horizon
- High price multiples (high P/E)
- Hot stocks
- High growth potential
So which style is better? Using the above short list, it looks like growth would be more favorable. The stocks are more popular with analysts and investors and they have a greater potential for growth. But one key point to growth stocks is that they are more expensive. They have higher than average price multiples, so you have to pay higher than average prices for those stocks.
Well then value stocks must be better, right? You pay less for the stock on average compared to other stocks in the market; you get a deal. But if the growth for the company is expected to be low, are you really getting a deal? Are the circumstances that are making the price of the stock low temporary or are they circumstances that are expected to continue for a long time?
As you can see there is no simple answer. Bummer, I know. But what we can do is look at academic research conducted on the subject and see if there is any evidence that one technique is better than the other.
One well-known study on the topic was conducted by Eugene Fama and Kenneth French. The pair wanted to see if there was a significant difference in returns when either a value or growth investment strategy was used.
The study includes companies from the NYSE, the American Stock Exchange, and the NASDAQ. These companies where separated into ten different groups based on book-to-price ratios. Group 1 contained those stocks that had the highest book-to-price ratios (or lowest P/E) and would have been considered the most “Value” stocks. Group 10 contained stocks that had the lowest book-to-price ratio (or highest P/E) and would be considered the most “Growth” stocks.
The evidence was quite clear. Over ten year periods, the value stocks beat the growth stocks by a large margin. Group 1 (value) saw its price multiply nearly 7 times in the ten year periods on average while group 10 (growth) saw its price multiply just over 2 times.
So does this mean that value investing is superior? Well, yes and no. Obviously if you were to have purchased value stocks in this situation you would have had superior returns, but the problem is that not every investor has the same time horizon. Some investors have shorter time horizons and may not see the same returns as this study lies out (remember that value investors usually need to hold their investments for 5+ years).
So what about the short term?
There is another study conducted by Narasimhan Jegadeesh and Sheridan Titman. This study focuses on momentum trading and tries to determine the optimal holding period for that particular investment strategy.
The study consisted of shorting (betting stocks will go down in price) companies that did poorly in the past 6 months and buying companies that have done well in the past 6 months. Then they tracked the success of the portfolio and determined what the optimal holding periods were.
The results were interesting. In the very short-term (less than 6 months), the return averaged between 2-6%. The returns peaked at almost 10% around the 12 month holding period and then began to diminish by almost half near the 24 month holding period range.
So, according to this research momentum trading can work as long as you hold the investment for the right amount of time.
Well that’s no better! We have proof that both work, but no proof of which is better! I think that this is where the problem lies. I truly believe that there is no perfect investment strategy, if there was then everyone would use it and it too would eventually become a non-perfect strategy because everyone would be following it.
Instead I believe there are good trading strategies. And each of those strategies has a particular kind of investor with a particular type of personality that best suits that particular strategy. Let me explain…
To Each Their Own
Value investing is obviously a great method for investing. The Fama French study proves that. But its success depends on a few key points.
The time horizon for the investment needs to be long. It requires the investor to hold on to the security for many years (at least 3 years and preferably over 10). This is because the stock needs time to bounce back from the unfavorable position it was in that made the price low in the first place. This can be difficult for some investors because you have to try and resist the urge to sell when things get bumpy. If you are the type who has to watch your stocks everyday or every week, then this strategy could be nerve racking for you.
The strategy also requires you to buy stocks when everyone else hates it. This is a hard thing to do because influence from others can play a big role in how your investment brain makes decisions, especially if that influence is coming from a professional such as an analyst. You have to have an iron stomach and be able to bet against the norm (what some would call a contrarian).
Growth (momentum) investing can also be profitable as demonstrated by the Jegadeesh Titman study. But it too has certain key points that are dependent on its success.
Growth investing favors the short-term, but not just any short-term; the 10-13 month period seems to provide the best results on average historically. This means that you have to have the patience to hold the stock, but you also have to watch the stock and news surrounding the stock carefully to make sure that the situation has not suddenly changed. If you are the type who does not like to constantly watch their investments, then this strategy could start to feel a lot like work and you may find yourself stressing out.
The high price multiple nature of the momentum strategy also means that you need to pay a premium for the stock. It also means that the stock needs to appreciate even further to gain some sort of return. This could be difficult if the market as a whole goes sour or if the company starts to miss expectations.
The truth is you need to match your investment style with your personality.
A value investor needs the following traits:
- Long-Term Focus: Must be able to hold a security for the long-term and be able to tolerate any price movements that may happen in that time.
- Contrarian: Must be able to buy a stock when others are ignoring it. Must not buy a stock when everyone else wants to buy it. There is a saying by Warren Buffet that goes something like, “Be cautious when everyone else is greedy and be greedy when everyone else is cautious.”
A growth investor needs the following traits:
- Attention: Must keep an eye on the stock and news surrounding the stock. Must be willing to sell if the situation changes.
- Short-term Focus: Must be willing to do frequent trading (which results in larger transaction fees). Must also be able to sell at the right time; you cannot believe that the rising price will last forever.
So which style do I think is best or which style suits me the best? Well, I tend to lean towards value, but there are circumstances when it makes sense to go for growth.
How I Feel about the Whole Thing
I really like two key points about value investing. The first is a long time horizon. I feel like to succeed as an investor in the stock market you have to think about the long-term. The key word here is “investing”. I feel that if you are trying to make a profit in the short-term in the stock market, then you are speculating, not investing.
The second is the low price multiples. To me it just makes sense to buy a stock cheap, not when it’s expensive. The age old simple rule of finance is to buy low and sell high. The logic is really that simple, but the practice can be somewhat of a challenge.
But here is where I venture off of value investing. I don’t want to just buy any company. I want a company that has a strong earnings history, strong ROE, low debt, and a predictable future cash flow. I want a company that will last another 50 years and has a competitive advantage that stops competition from taking over. This means that a low price multiple won’t simply do; there are other factors that I want to know to help shape my decision.
I do not like to engage in frequent trading simply because high trading leads to high costs. I believe that it should not take hundreds or even dozens of trades to become profitable. I believe it only takes a few good trades, invested in good companies, held for a long time to have investing success.
Growth investing can usually lead to frequent trading, but this does not mean I would never consider a growth stock.
I would be willing to pay a higher relative price for a growth stock if it makes economic sense. What I mean is that if the future earning potential is high, the earnings track record is strong, the business is easy to understand, and it meets all my other criteria, then I would not mind if I pay a high price multiple for the company if the present value is more than the market price. If my discounted cash flow valuation of the company comes in higher than the current market price (despite having a high price multiple) then it may make sense to buy.
What about the Average Investor?
For the 99%
Simply put, I think value investing is better for the average investor. It requires less work to execute and maintain and requires less trading which keeps costs down. It also favors a long time horizon which most investors have (assuming most investors are saving for retirement).
But individual stock picking can be risky, expensive, and time consuming for the average investor. What might make more sense for the average investor is to develop a diversified portfolio full of indexed mutual funds or ETFs with the right mix of equities and fixed income securities to meet their risk profile.
Again, I’d like to point out that there is no perfect strategy for everyone. If you are not sure what strategy you should use then talk to a professional who can give you some guidance.
To me, the only truly wrong investment decision is one that is made without thought and care or an investment that is simply never made.
Thanks for reading and good luck out there!
How do you feel about the whole value vs. growth discussion? Do you favor one or the other? Do you know of some other academic research that proves one better than the other? Leave a comment below and start a discussion!
Warning/Disclaimer: The above article is not investment advice for an investor to implement. It is meant to educate the investor about options available for investment. Talk to a licensed and accredited financial professional about investment strategies that are best for you and your situation.