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6 May 2016

Should you invest in value or growth stocks?

By James Yardley, Senior Research Analyst

Just like the age-old cats versus dogs or the Saturday night squabble over Strictly Come Dancing versus the
X Factor, the question of 'value' or 'growth' investing has been sparking impassioned debate for years.

When it comes to choosing investments, you may often notice a fund or a particular manager is described as having a value or a growth bias, but what does this really mean? And is one style truly superior to the other? We take a look.

What are ‘value’ and ‘growth’ stocks?

Value stocks are stocks that are ‘cheap’, put simply. The most traditional way of calculating this is in terms of 'book value' or the net assets on a company’s balance sheet (assets minus liabilities). If the company’s net assets are greater than the value of the company implied by its stock price (its market capitalisation), it is considered to be a value stock.

So, for example, if a company's net assets are worth £5bn and its market capitalisation is £4bn, the company is trading below book value and therefore would be said to be in value territory.

Value investing is also associated with buying stocks that are currently out of favour and trading on low price to earnings (PE) multiples. (The PE ratio is probably the most common way to value a company, measuring its current share price relative to its earnings per share.)

By contrast, growth stocks usually trade on high PEs, have above average growth and are expected to earn a lot more in the future.

Which delivers better returns?

Historically, over the long-run, investing in value stocks has delivered better returns than investing in growth stocks. The theory goes that investors tend to overpay for exciting new growth companies and often these companies fail to meet their high expectations. By contrast, investors underestimate the ability for cheap value stocks to recover.

For example, in the graph below, you can see UK investors made almost twice as much by investing in value stocks between April 2000 and 2014.

So it's pretty simple, right – invest in value for the long-run? Perhaps not any more. Looking at the past two years, growth stocks have started outperforming value stocks in a big way (see graph below).

And while two years might seem like a relatively short period, it's worth noting that in Europe growth shares have been outperforming value over the past nine years1.

The question is why is this and is the trend likely to continue or reverse?

No more outsmarting the market?

One reason that's been suggested is that says investors will change their behaviour to take advantage of market anomalies. Meaning, while you may be able to beat the market for a short period with a certain style or strategy, eventually the market will realise and you will no longer be able to outperform in the same way.

Has this happened with value investing? The value effect is now extremely well-known and understood by investors, so maybe the market has corrected itself. Perhaps the market has even gone too far the other way and now overpays for value stocks?

Low interest rates favour growth stocks

Another reason, which has perhaps slightly more gravitas, is that growth may have started to outperform due to historically low interest rates. To understand why this matters, think of the 'time value of money' concept, which essentially tells us that money today is worth more than money tomorrow.

Provided money can earn interest, it is better to receive that money as soon as possible. Look at these two examples to see how this concept is affected by low interest rates:

  • Imagine you invest $100 at a 10% interest rate in the bank. In one year's time, it will be worth $110. By this logic, $100 received in one year's time is only worth $90.91 today.
  • So thinking a bit more into the future, $100 in ten years' time is worth just $38.55 today if interest rates are 10%. But if interest rates are 1%, $100 in ten years' time is worth $90.53 today – a huge difference.

So thinking about this in term's of a company's cash flow – if interest rates are high, the cash flow is worth less in the future. But if interest rates are low, as they are today, cash flows should be worth more in the future. Growth stocks get a lot of more of their cash flows in the future compared to value stocks. That's why they're so popular in the current environment and that's why people have been willing to pay a bit extra for them.

Which style should you invest in today?

So is this going to change? Global growth doesn't looks likely to rebound strongly nor interest rates likely to go up markedly any time soon. So if you assume low interest rates, low growth for longer, growth stocks could continue to outperform.

Having said that, if we think we've gone as low as we're going to go for both, now may be a good time to invest in a company that's 'cheap', as long as you're prepared to be patient. The power of the value factor over time should not be underestimated and therefore a mix of both styles is probably the best way to insulate your portfolio for the long-run.

Elite Rated value funds

Elite Rated Schroder Recovery is a true deep-value fund that invests in the cheapest and most unloved companies in the UK. Investors need to have a high tolerance for volatility, as this fund is liable to be at the bottom of the performance tables one year and top the next.

A milder value biased fund is the Elite Rated Jupiter UK Special Situations, managed by Ben Whitmore. Ben is a true value manager who believes that company earnings forecasts are difficult to predict with any accuracy. As such, he focuses on buying enduring companies that are cheaply valued.

Elite Rated growth funds

A solid growth alternative is the Elite Rated AXA Framlington UK Select Opportunities, managed by Nigel Thomas. Nigel is one of the UK's best performing managers and he is an example of how the growth style can be made to work over the longer term as long as you don't overpay.

For those looking for extremely fast growth, I like the Elite Rated Baillie Gifford Global Discovery. This super fast growth fund buys companies with tremendous prospects. It tends to have a bias to smaller companies as these can grow faster. The downside of this fund is many of its companies are extremely expensive and this leads to it being very volatile. It has a strong long-term track record, but its not a fund for the faint hearted.

Where to next?

1FE Analytics, MSCI Europe ex UK Growth v MSCI Europe ex UK Value, TR in GBP, 02/05/2007–02/05/2016, accessed 03/05/2016

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. James's views are his own and do not constitute financial advice.

©2016 FundCalibre Ltd. All Rights Reserved. The information, data, analyses, and opinions contained herein (1) include the proprietary information of FundCalibre, (2) may not be copied or redistributed without prior permission, (3) do not constitute investment advice offered by FundCalibre, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warranted to be correct, complete, or accurate. FundCalibre, shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses, or opinions or their use.