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Value Vs Growth Investing: Why You Should Pick Value All

the Way
valuestockguide.com/valueinvesting/value-versus-growth-investing

Shailesh Kumar July 13, 2017

Forget about value versus growth investing.

There’s a lot of debate around the philosophy


of value versus growth investing. Value
investing is the process of investing in stocks
that are undervalued relative to their intrinsic
value, while growth investing refers to the
philosophy of investing in companies that
have consistent earnings growth as well as
the promise of above-average growth in the
future.

Wall Street analysts and Ivy League


academics may debate the differences between the two approaches, making it seem like one
has to choose between one or the other but the world doesn’t always fall into neat little boxes;
it’s clear that value investing is the only way to invest.

Value is the Winner


Value stocks empirically outperform growth stocks in the long run.

Research conducted by Ibbotson shows that value stocks have left growth stocks in their dust
over a 40 year period spanning 1968-2008. This finding holds true for small, mid and large cap
stocks.

Academics typically classify value stocks by sorting a list of stocks on various price multiples:
price-to-earnings, price-to-cash, price-to-book, etc. These multiples are used to identify stocks
with low prices relative to the aforementioned measures (value stocks). The stocks that have
higher relative prices are defined as “growth stocks”.

Fama and French (1992) examined the performance of value stocks versus growth stocks in
different markets across the globe and found that value stocks were the winner in twelve of
thirteen markets. The study spanned 20 years, from 1975 to 1995 and is an extremely
influential study in this area of research.

Bauman, Conover and Miller (1998) built on Fama and French’s research, further
corroborating the evidence. They found that value stocks outperformed growth stocks in in a
majority of 21 international markets over a 10-year period.
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Capaul, Rowley and Sharpe (1993) found that value stocks selected using price-to-book ratios
outperformed growth stocks in France, Germany, Japan and the UK between the years of
1981-92.

Not to belabor the point but a 90 year study from Bank of America in conjunction with Merrill
Lynch found that value stocks generated an average return of 16.7% annually. Growth stocks
did well, but could not match their value stock counterparts (12.4%).

All this to say, the outperformance of value stocks is a phenomenon that exists not just in US
markets, but all over the world, and the finding holds across different time periods and
methodologies.

There is one caveat: the BoA/ML study did find that growth stocks tended to outperform value
stocks when the economy was contracting. Over the very long run however, you are better off
with a value-based approach, with value stocks beating growth stocks in 3 out of every 5
years.

Why Value Wins the Value Versus Growth Investing


Showdown?
Another study conducted by Bauman and Miller of Northern Illinois University give us some
insight into why value stocks outperform on a consistent basis. The authors looked at a list of
stocks broken out into 4 different groups, sorted by low to high price-to-earnings ratios. Group
A, stocks with the lowest price-to-earnings ratios, were the ones that surprised most on
earnings. In other words, these value stocks beat market expectations while the more
expensive stocks tend to miss their high earnings target expectations, leading to relative
underperformance.

It’s easy to see why growth stocks underperform when defining them this way, and reversion
to the mean plays a big part. Essentially many of these studies define growth stocks as having
high P/E ratios (or another single multiple, or a combination of a few different ones) and value
stocks as having low P/E ratios then performance is negatively impacted by the group of
growth stocks who move from high P/E groups to a lower P/E group over time.

In fact the effect is so pronounced, that if you were able to identify these stocks ahead of time
and exclude them, then growth stocks could conceivably outperform value stocks. That’s
exactly what George Athanassakos, Professor of Finance at Ivey Business School, found in
his study of the Canadian market from 1986-2014.

The Final Word on Value Vs. Growth


The classification between value investing and growth investing is misleading. If one assumes
the mindset of a growth investor, it is hard to imagine paying a premium for companies that
show the promise of above-average growth. Investors do not want to pay more than they need
to, which is why the philosophy of GARP is popular amongst growth investors. Growth at a
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reasonable price, GARP, is a strategy that combines the ideas of value and growth investing.
Essentially, the idea is to find businesses that have consistently strong and increasing
earnings but aren’t overpriced.

There’s a reason value investing is such a powerful strategy. By buying stocks at a discount to
intrinsic value, an investor is able to protect their downside and build in a margin of safety.
Margin of safety simply refers to the difference between the share price and intrinsic price per
share. If you think about it, there’s a lot less risk in buying a million dollar company for
$500,000 than for $2 million. Pair this pricing advantage with strong future earnings growth
then you put yourself in a great position to take advantage of asymmetrical returns.

What people really consider growth investing is more like momentum investing: trying to ride
the coattails of stocks that have shown strong growth in the past and are expected to continue
growing in the future. Investing in this manner is basically equivalent to speculation.

At the end of the day intelligent investing is value investing, and screening for consistently
strong earnings should be on any value investor’s checklist, and stocks selected using value
investing principles can serve as the growth component of your overall portfolio. There’s no
need to differentiate between two categories of stocks, instead expand your understanding of
what constitutes intrinsic value.

Further Reading
https://faculty.fuqua.duke.edu/~charvey/Teaching/IntesaBci_2001/FF_Value_versus.pdf

https://www.ivey.uwo.ca/cmsmedia/3775505/growth_versus_value_and_large-
cap_versus_small-cap_stocks_in_international_markets.pdf

http://www.merrilledge.com/Publish/Content/application/pdf/GWMOL/GlobalStrategyApictureguid
etofinancialmarketssince1800.pdf

https://www.ivey.uwo.ca/cmsmedia/3775496/value_vs_growth_stock_returns_and_the_value_pr
emium.pdf

Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor,
Plousio and Financial Choice.

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