Do Growth Stocks Outperform Value Stocks?

What do you know about investment style?  The two most talked about are Value and Growth.  Could they be a selling distinction so advisors will have something to talk about.  There are some who think there is no difference.  Hear Warren Buffett,

“Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication.”

Perhaps there is something in there we can understand.  Perhaps style does not matter.  If it does not, then we waste our time to study it.

Start with a definition.

  1. A growth stock is one whose earnings we expect to grow more quickly than the market as a whole.
  2. A value stock is one that the market presently values at less than its intrinsic ability to earn.

Looking at growth, most of the stocks that fit are new companies, often in new industries and often with no earnings.  In percentage terms, earnings can grow quickly when the base is low, but when the growth happens the price to earnings multiplier tends to fall.  A company like Facebook sells today at 70 times earnings.  Would it be reasonable to assume that if the earnings double the stock price will double too?  Maybe, but that would add $330 billion to its market cap.  Walmart is worth $220 billion.  Adding 1.5 Walmarts to your valuation is the work of serious people.  So even if earnings grow very quickly, the stock will approach the industry multiple and the value change will be less than anticipated.

A simple approach is estimate what your prospective security would trade for if earnings increased by a hundred fold and the stock traded at the industry average p/e ratio.

Harder to do with high value securities that have no earnings.  LinkedIn for example.

Value on the other hand is a bit easier to discover.  The companies tend to be mature.  There are no startup, value stocks.  You are looking for businesses who have the ability to earn, to grow, perhaps to have a dominant market share, to be a low cost producer, and to have pricing power.  They should be immune to paradigm shifts.  Businesses with a lot of debt will be different as rates rise.  Technology changes may matter.  Honorable management is a necessity.  Family controlled businesses are often a fertile area to explore.  We look for these because there are fewer variables to assess.

The value/growth comparison is a distraction.  Money cannot tell where it comes from, nor how it came to be. A bit like baseball.  A walk, stolen base, ground out to the right side and a sacrifice fly scores one run.  Just like a mammoth home run, but no one remembers the manufactured run.

The growth approach works sometimes, usually in an up market.  Value lags there.  Growth falls further later.  I suppose if an investor had exquisite timing skills, that might not matter.  Some growth companies do not survive.  Value companies tend to.  Dividends matter.  They are a limit on management profligacy.  Homeless money in a corporation often leads to sketchy decisions.

Eventually, a stock is worth what it can earn.  There will be pricing anomalies along the way because Mr. Market is not entirely rational.  For most investors, buying a sound business when Mr. Market undervalues, is a sound practice.  It is not foolproof but it tends to produce adequate results.

Studies have shown that Value outperforms over long periods, but you will not own the whole category.  Your individual stocks may deny that result.  Sound research and sound, but often frightening decisions, will win out.

Test question.  Is Apple a growth stock or a value stock?

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  866-285-7772

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