The growth vs. value debate is heating up once again as investors try to determine the best strategy to navigate the current economic crisis.
The challenging macro-economic conditions are revealing flaws in both these strategies. For instance, a few companies that were considered to be safe and sound investments for value investors, notably the leading banks in the U.S., are reeling from the recession, and the sector performance has lagged the broad market by a considerable margin. On the other hand, some high-growth companies are finding it difficult to remain solvent as the policy of using massive cash burn and debt issuance to produce unprofitable growth is coming back to bite them.
Based on this backdrop, it seems that striking a balance between the two investing techniques is the best course of action to generate alpha returns.
A snapshot of historical performance
The information technology sector has dominated the market performance since the fallout of the financial crisis, and accordingly, growth stocks have outperformed value consistently. The below chart (MSCI world value/growth relative performance and S&P 500 downturns) confirms that the last decade has been the worst 10-year period for value strategies in recent memory.
Source: JPMorgan (JPM) Asset Management
This is, however, just one side of the story. According to data from JPMorgan, value investing techniques have provided substantially higher returns than their growth counterparts in the 80 years from 1927 to 2007. This, in fact, prompted many fund managers to ignore growth stocks altogether leading up to the market crash of 2008.
A Morningstar research paper prepared in 2019 by analyst Tom Lauricella made the case that the performance of growth and value stocks is cyclical and is dependent on the underlying macro-economic and geopolitical conditions. This sends a warning signal for investors who build their portfolios only based on one of these strategies.
The case for and against value stocks
Value investing is the process of betting on shares of companies that are seemingly cheaper than the rest of the market or sector from the perspective of valuation multiples such as price-earnings, price-book and other methods of estimating intrinsic value. The logic behind investing in such companies is that the market will identify the mispricing in the future, leading to very attractive returns as the price converges with the perceived intrinsic value of a company.
There are a few reasons to take faith in this strategy. First, value investing is a tried and tested method. For instance, the success of Warren Buffett (Trades, Portfolio), Charlie Munger (Trades, Portfolio) and Seth Klarman (Trades, Portfolio) can be attributed to prudent decisions to invest in companies that were out of favor among the majority of market participants. Banks were ignored by many investors during the financial crisis, and even the shrewdest investors wanted to steer clear of this sector, but Buffett invested billions of dollars in this beaten down and forgotten sector, a decision that would prove to be value accretive a few years down the line.
Second, a follower of value investing fundamentals is likely to invest in mature, cash flow positive companies, thereby reducing the risk of failure. Even in the face of a catastrophic event, most such companies can recover sooner than young companies as a result of the stability in their business operations.
Third, it seems logical to invest in companies that are cheap or undervalued in comparison to their intrinsic value estimate. To buy things when the price is marked down is an everyday practice of consumers and it makes sense to do the same when it comes to investing as well.
The primary drawback of this strategy is its backward-looking nature, which could result in investors altogether missing a possible catastrophic event that might arise in the future. On the other hand, not emphasizing enough on the growth prospects of a company could eventually lead to market-lagging returns if a young company begins to disrupt and dominate an industry. A classic example is the market performance of Walmart Inc. (WMT, Financial) and Amazon.com Inc. (AMZN, Financial) in the last decade.
Source: GuruFocus
Amazon was never a value stock at any point in time in the last decade, and it might not fall into this category for at least another couple of decades going by the exponential growth of company revenue and earnings. Missing out on these types of investment opportunities remains a risk as long as an investor follows value investing principles.
The case for and against growth stocks
Stock markets are perceived to be forward-looking, and this is at the heart of investing in young, fast-growing companies that are expected to disrupt the traditional way of doing business. Even though a company might be bringing in next to nothing in earnings at present, with the right strategy and a visionary management a young business could transform itself into a multi-billion-dollar organization.
Facebook Inc. (FB, Financial), Shopify Inc. (SHOP, Financial) and Netflix, Inc. (NFLX, Financial) are classic examples for such companies. None of these companies would have appealed to a value investor at any given time in the last few years, but the S&P 500 index has been driven higher as a result of the success of these companies that were very young or non-existent ten years ago.
Peter Lynch’s success at the helm of the Fidelity Magellan fund is the best example of the attractive returns that can be generated by investing in young companies. In his book, "One Up On Wall Street," Lynch wrote:
“Big companies have small moves. Small companies have big moves. Over the long term, it’s better to buy stocks in small companies.”
Most of the time, high growth companies tend to trade at earnings multiples above that of the market and mature companies. This is because investors bid up the share price in anticipation of exponential growth in the future that would bring back the valuation ratios to a more justifiable level.
The obvious risk of following a growth investing strategy is the possibility of losing the entire invested capital in one company. Small companies are extremely vulnerable to external developments such as recessions. For example, the current economic downturn has pushed more than 70 well-known companies, including Hertz Global Holdings, Inc. (HTZ) and Chesapeake Energy Corporation (CHKAQ), into bankruptcy. Because the focus of a growth investor would be on the future and not the past of a company, the possibility of an entire wipeout of invested capital is higher.
The importance of a customized strategy
Both value and growth investing techniques have positives and negatives. A more practical way to approach investing is to strike a balance between the two and develop a personalized process to account for the investment objectives and the risk tolerance of an individual investor. This will help an investor build an all-weather portfolio that could deliver acceptable returns under many market and economic conditions.
In a research report about this subject, The Glenview Trust Company wrote:
“Mixing growth and value funds within your portfolio allows you to potentially gain as the market moves through different cycles. Although past performance cannot guarantee future results, value stocks, often those of cyclical industries, tend to do well early in an economic recovery; growth stocks, on the other hand, tend to outperform during bull markets, which are normally fueled by falling interest rates and rising company earnings. But the good news is you don't have to choose - combining growth and value funds may present a prudent strategy for balancing risk and return over the long term.”
The best course of action is to prepare an investment strategy statement to correctly identify the limits and desires of an investor, which could then be used to design a customized strategy. A blend of value and growth is likely to reduce the volatility of a portfolio while exposing the investor to potentially higher rewards in comparison to betting on cheap stocks.
Takeaway
Building a winning investment portfolio is not an easy task. One of the most important steps in the process is to follow a strategy that fits well with the investment objectives and the risk tolerance of an investor. Most of the time, however, investors blindly follow an investment discipline that does little to help them achieve the desired returns. An innovative way to think of the investing process is to combine both value and growth investing fundamentals to create a customized solution to identify attractive investment opportunities. Such a portfolio is likely to be better diversified as well, which is another benefit of striking a balance between the two strategies.
Disclosure: I own Facebook shares.
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