Growth vs. Value Stocks – Which Has the Best Track Record?


May 5, 2017

More than 4,000 companies are traded on the major stock exchanges in the United States, and another 15,000 or so are traded off the major U.S. exchanges. It is challenging to determine which ones might grow into valuable companies versus which ones might be duds. There are many categories of stocks, but our favorite is Value stocks. They may become your favorite once you understand what we think makes them stand out. Value stocks tend to have solid fundamentals, but trade below our estimated fair value for the company’s shares. Warren Buffett has described the category as buying “outstanding companies at a sensible price.”

 

You’ve probably also heard about Growth stocks. Growth stocks are companies that may not have great fundamentals, but investors believe future earnings per share will be substantially higher than current levels. Amazon (NYSE: AMZN) and Facebook (NYSE: FB)[1] are examples of growth stocks. Both companies are highly valued because of expected growth potential – not for their current earnings per share or cash reserves. Contrast that with Value stocks such as General Electric (NYSE: GE) or General Motors (NYSE: GM)[2]. These companies have stable (but still growing) businesses and pay investors for holding shares via a dividend, although continued payment of dividends cannot be guaranteed. Some may consider these stocks boring, but they have been historically lucrative in the long run.

Growth stocks are often young companies whose earnings and sales are expected to increase at a rate much higher than the average company. We believe that most investors in growth stocks pre-pay for potential growth that may or may not materialize. Conversely, we believe that value stocks trade below their estimated fair value for the company’s shares, so are essentially “on sale.” Their prices are discounted based on bad news or low expectations that may or may not materialize.

Growth stocks are exciting when you think about companies like Amazon (NYSE: AMZN) and Facebook (NYSE: FB). But Twitter (NYSE: TWTR) was also a growth stock that soared to great highs and is now trading at less than half of its value on opening day. Twitter’s IPO began at $26 and closed at $44.90 on its first day of trading.[3] It peaked at $69 in 2013 as early investors expected the company to grow and become profitable. But they pre-paid for growth that never materialized. Twitter never became profitable and lost billions of dollars.[4] Recently the stock was trading as low as $15[5]. Growth stocks may keep investors on the edge of their seats, but have been historically less likely to pay out over the long run.

How to identify a growth vs. value stock

To identify whether a stock is a Value or Growth stock, look at some of these key valuation metrics (As of 05.02.2017 using data from Bloomberg):

  1. Price-to-earnings (P/E) ratio: Divides the stock’s share price by its expected earnings per share to show how much an investor is willing to pay per dollar of the company’s earnings. A company with a low P/E is generally a Value stock and a company with a high P/E ratio is generally a Growth stock. The Russell 3000 Index, roughly 98% of the U.S. traded market by capitalization, has a P/E ratio of 20.6, while the Growth portion of the index has a P/E of 23.2 and the Value portion has a P/E of 18.4.
  2. Price-to-book (P/B) ratio: Divides the stock’s share price by its net assets and subtracts any intangible assets (non-physical assets such as patents and copyrights). This shows how much investors are willing to pay for each dollar of a company’s assets. A company with a low P/B is generally a Value stock and a company with a high P/B ratio is generally a Growth stock. The Russell 3000 Index has a P/B ratio of 2.9, while the Growth portion of the index has a P/E of 5.7 and the Value portion has a P/B of 2.0.
  3. Price-to-sales (P/S) ratio: Divides the stock’s share price by its annual sales. This shows how much investors are willing to pay for each dollar of a company’s sales. A company with a low P/S is generally a Value stock and a company with a high P/S ratio is generally a Growth stock. The Russell 3000 Index has a P/S ratio of 1.9, while the Growth portion of the index has a P/S of 1.7 and the Value portion has a P/S of 2.2.

The Case for Value Investing

We believe that you pre-pay for expectations in growth stocks, whereas value stocks have already been discounted. This is why over the long-term, growth stocks have trailed value stocks, returning an annualized average of 9.4% while value stocks have returned an annualized average of 13.6% over the same time period.

Download The Case for Value Investing

Why we favor value stocks over growth stocks

As a shareholder, you own some fraction of future cash flow from the company in which you own shares. You want to pay as little as possible for that future cash flow. When you pay as little as possible for those cash flows, you minimize the potentially negative consequence of misestimating where those cash flows might be a few years down the road.

In buying at a discount, we are looking to a combination of two primary forces to potentially lift return:

  1. Mean reversion. That is, we believe that a company that trades below the average will return to the average over time.
  2. Growth or other company-specific improvement.

Circling back to the General Motors example above, in 2016, GM earned $6.12 per share. The closing price on at the end of the year was $34.84. So, the price to earnings ratio is 5.7. If GM’s P/E grows back to the Russell 3000 index average of 20.6, we might expect the company to trade at $126 per share. The second possible source of appreciation is improvement in the company’s earnings, sales or fundamental metrics. This time, instead of the P/E ratio expanding to the market average, GM might make more money.

Consider: What if GM made $7 in 2017 and the P/E ratio stays fixed at 5.7? The stock price would rise to $40. That is 14.8% growth in stock price enabled by an earnings growth of $0.88 per share in just 1 year. While this example is simplistic, it illustrates that we generally look for both mean reversion and growth to affect stock prices over the long term. We believe the problem with Growth stocks is that investors only benefit from force #2, as the mean reversion force #1 part plays against investors.

Figure 1:

Value vs. Growth Stocks Annualized Total Return

 

 

While Value stocks don’t win in every period, a long-term view should find that investing in high-quality, Value stocks in a diversified portfolio is a worthwhile endeavor…

Figure 2:

Hypothetical value of growth vs. value stocks based on $100 investment in 06/30/1926

 

Hypothetical performance is shown for illustrative purposes only and should not be interpreted as an indication of performance of any AFAM portfolio.

…particularly compared to other asset classes.

Figure 3:

Long-term returns of different classifications of stocks

 

The above chart demonstrates how the annualized return on Value stocks meaningfully outperforms Growth stocks.

Your next question might be, “Is now a good time to purchase value stocks?” We think the answer is always “Yes!” for investors with a broadly diversified portfolio of Value stocks and a long-term investment horizon.

Figure 4:

Performance: Value vs. Growth stocks over period of time held

Summary

We are bargain hunters at our core – in the stock market and the supermarket. That means we don’t believe in paying more than something is worth, no matter how fancy the packaging. Our philosophy may not be the most exciting, but it has proven to be lucrative over the last four decades. It requires expertise in picking stocks as well as patience in staying the course through market fluctuations. As a recent Baron’s article said of our value investing strategy, “It pays to have nerves of steel.”

The Case for Value Investing

We believe that you pre-pay for expectations in growth stocks, whereas value stocks have already been discounted. This is why over the long-term, growth stocks have trailed value stocks, returning an annualized average of 9.4% while value stocks have returned an annualized average of 13.6% over the same time period.

Download The Case for Value Investing

[1] As of May 10, 2017
[2] As of May 10, 2017
[3] http://money.cnn.com/2013/11/07/technology/social/twitter-ipo-stock/
[4] http://money.cnn.com/2016/03/21/technology/twitter-10th-anniversary/
[5] As of May 2017

 

 

No guarantee of investment performance or dividend payment is being provided and no inference to the contrary should be made.

Please note that the illustrated depictions of value and growth stocks are not intended to be representative of any individual product available through AFAM Capital, Inc.

Value stocks are shares of a company with solid fundamentals that are priced below those of its peers, based on analysis of price/earnings ratio, yield, and other factors.

Growth stocks are shares of a company that are priced above those of its peers, based on analysis of price/earnings ratio, yield, and other factors.

The performance of growth stocks as illustrated in Figures 1-4 is comprised of 50% small growth stock returns and 50% large growth stock returns. The performance of value stocks as illustrated in Figures 1-4 is comprised of 50% small value stock returns and 50% large value stock returns. The performance of dividend paying stocks as illustrated in Figure 3 is comprised of the returns of the 30% highest dividend payers, 40% mid-range dividend payers, and 30% lowest dividend payers – calculated using dividend yield. The performance of non-dividend paying stocks as illustrated in Figure 3 is comprised of the returns of stocks that do not pay a dividend. All as of dates indicated, rebalanced monthly, and derived using data from Professors Eugene F. Fama and Kenneth R. French. http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

The performance of various bonds, Treasury Bills and inflation as illustrated in Figure 2 is derived using data from Ibbotson Associates: Long term corporate bonds are represented by Ibbotson Associates SBBI US LT Corp Total Return Index. Intermediate term government bonds are represented by the Ibbotson Associates SBBI US LT Govt Total Return Index. Treasury bills are represented by the Ibbotson Associates SBBI US 30 Day TBill Total Return Index. Inflation represented by the Ibbotson Associates SBBI US Inflation Index. It is not possible to invest directly in an index.

Standard Deviation is a measure of the dispersion of investment returns from the mean. A higher standard deviation indicates higher volatility.

Investing involves risk, principal loss is possible, and there can be no assurance that investment objectives will be achieved. The information presented herein is for discussion and illustrative purposes only and does not constitute investment advice. It is not a recommendation or an offer or solicitation to buy or sell any securities.

Information provided reflects AFAM’s views as of a particular time. Such views are subject to change at any point and AFAM shall not be obligated to provide notice of any change. While AFAM has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third party information presented herein.

185-AFAM-5/18/2017

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