Growth and value investing are two of the most popular investment styles around. So, what exactly are they, and what are the pros and cons?
Both styles provide us with some important insights that can be applied to any equity portfolio.
It has been generally observed that each style can greatly outperform the other during different investment environments.
The very early stages of a stock market recovery can be a good time to pursue this strategy, especially when a big sell-off has pushed equity values lower.
Just such was the case in 2009, when the financial crisis and stock market rout saw valuations pushed to historically low levels.
Using this strategy can mean a great deal of patience is required as you wait for a company´s fortunes to improve or the market to fully appreciate the stock´s value, or a combination of both.
So, how do you tell when a stock is undervalued?
One of the most widely used relative valuation metrics is the price-to-earnings ratio (P/E). It can provide a quick reference point as to where a stock is trading in relation to its peers.
It is calculated as:
- PE = share price/earnings per share
If the average P/E for an industry is currently 16 and a stock is trading at 8, then there is a chance the stock could be undervalued.
The next question is why the stock is trading at that level, and that´s where solid research comes in.
We need to understand the business inside out and ascertain why its trading beneath the level of its peer group and what the prospects for improvement are.
If we face a situation where a big stock market sell-off has pushed the whole industry average P/E to 6, then it could be more of a case of waiting until the broader economic picture improves.
Understanding the business
But even in this scenario, we need to thoroughly understand the business we are investing in. It could be that the economic environment has become so difficult that some of the companies on apparent low P/Es will simply not survive.
A problem can also be that the current P/E becomes misleading, because it´s based on a set of earnings numbers that are no longer relevant. This could well be the case during a rapid deterioration in economic conditions.
In this situation, we should try to project what the next year´s earnings are likely to be and put that into the equation instead.
Real-world examples of value investing stocks
The stock market rout of 2008/2009 provides some stark real-world examples of shares that reached compelling valuations based on metrics such as P/E.
As global equities slumped, the FTSE 100 index came off a peak of 6,732.40 in June 2007, sliding to just 3,530.73 by March 2009, a fall of around 47%.
Certain industrial names could be scooped up at ultra-low valuations at this time, with industrials generally viewed as being particularly sensitive to changing market conditions.
In the UK, good examples of value investing stocks were names such as industrial support services company Cape and wheel maker Titan Europe, both of which have since been acquired by overseas rivals.
If you got your timing right, you could have made 10 times your money on Titan and even 20 times your money on Cape. This would have meant buying in at the absolute lows of 2009 and then selling out within a few years, once sentiment had improved.
Exceptions not the norm
This makes value investing sound extremely exciting, but it should be remembered that the recent financial crisis was quite an exceptional time in our history.
While it illustrates the concept well, it can take a lot longer for so-called value investments to come good and usually the returns are a lot lower than in these cases.
It also requires a great deal of research and care; you don´t want to buy into a stock that looks cheap simply because it is about to go bust.
Growth investing strategy
Growth investing strategy is all about buying into stocks that are growing earnings at an above average rate.
The technology sector is currently the place for growth investing. Chinese internet names such as Tencent and Alibaba are good examples of growth stocks that have been generating excellent returns for investors of late.
Both names are benefiting as a rapidly increasing proportion of China´s 1.4 billion population goes online and transacts more of their daily lives through the internet.
The companies have also been focusing on growing their revenues outside China.
Share price doubled
Shares in Alibaba, which is now one of the world's largest e-commerce companies, have doubled over the past year. The group has recently been reporting strong sales growth from its e-commerce platforms as well as rapid expansion across its cloud and online entertainment businesses.
In a similar vein, Tencent operates internet and mobile related services and is behind the popular WeChat messaging app, the largest of its kind in China.
Super strong sales growth is being driven by the rising popularity of Tencent´s mobile games. The shares are up by around 50% over the past year.
Those of us who like the idea of buying into fast growing companies can still use metrics to judge their relative value.
A popular metric that can be employed to identify the relative attractiveness of growth stocks is PEG.
It essentially builds on the PE ratio to take growth into account. It is calculated as:
- PE/annual earnings per share growth.
The ratio will give us a value in the range of 0 to 1. On this measure, the lower the ratio is in the range, the more attractively priced a growth stock is likely to be.
Peter Lynch became one of the most famous growth investors of all time through his impressive management of Fidelity´s Magellan Fund. During his stewardship, from 1977 to 1990, the fund generated an average annual return of an astounding 29.2%.
The PEG ratio was one of Lynch´s favourite metrics as he applied the logic that the faster a company´s earnings are growing, the more it should be worth.
Among the many celebrated value investment managers is Bill Miller, who made his name for beating the return of the S&P 500 index over 15 consecutive years, from 1991 to 2005. This was when he headed up what was then known as the Legg Mason Value Trust.
Miller is famed for his focus on intrinsic value, refusing to rule out investment in big technology names if he believes their PE multiples are fully justified.
He now heads up his own investment firm, Miller Value Partners.
Growth investing – targeting companies that have been growing earnings at an above average pace – has been a good strategy of late.
For instance, the iShares S&P 500 Growth ETF is up by around 26% over the past year versus about 19% for the iShares S&P 500 Value ETF.
As would be expected given the growth style´s strong performance, technology has been one of the best performing US equities sectors over the year, rising by about 32%.
Meanwhile, certain sectors in the value camp have sharply underperformed, with consumer staples and energy returning 1.2% and -3.2% respectively.
On the one hand, global economic growth has been picking up, making it more likely that companies can achieve above average earnings growth.
Arguably though, there is also another factor at play; rapid technological advancement.
Over recent years, we have been witnessing strong growth in internet and mobile related technology, but also the emergence of new areas such as electric cars.
Pros and cons
There have clearly been occasions when the general economic environment favours value over growth or as it appears at present, growth over value.
This could be a major flaw in solely pursuing one strategy over the other. Get your timing more or less right though, and you could turn this apparent flaw into a major investing advantage.
Pursuing value strategies in the very early phase of a stock market recovery can potentially be very rewarding.
Conversely, when the global economy is growing above trend, it makes sense to be invested in growthier sectors such as technology.
Timing of investments
Since it´s unlikely that we will always be able to get our timing right, it could be worth keeping at least some of our money invested in core equities strategies that are neither wholly value or growth orientated by their nature.
There are however some powerful opportunities to be uncovered by tilting towards one style over the other at certain times.