Growth vs. Value: III. Comparing the Two

A Brief Comparison of the Two Investment Styles:

Growth Value

stock volatility high                                   low

character aggressive                         defensive

upside high                                   limited

downside can be high                         low

firms have very bright future               cheap assets

outperforms bull market                         bear market

benefit from market greed market fear

(sell high)                           (buy low)

uncertainty extent of rise                       timing of rise

portfolio size 50 issues                             100

Performance History

During the Seventies and the Eighties, whether an investment manager practiced the growth style or value style made little difference to overall returns.  Decisions about size (market capitalization) or US vs. international were much more important, I think.  In a given year, growth investors might outpace their value rivals, but the following year the situation would likely be reversed.  At worst, the returns over a business cycle would be comparable.

This performance pattern changed markedly during the Nineties.  

The Eighties saw a massive restructuring of American industry, facilitated by the junk bond tycoons.  This coincided, oddly enough, with a deepening despair that the US was being permanently supplanted by Japan in all areas of economic activity, especially manufacturing.  As the stock market typically deals with conventional wisdom, when a bull market emerged in 1992 it was led by those beaten-down manufacturing stocks.  Value outperformed growth by a very wide margin for about two years.

This period was followed by the tech boom of the latter half of the Nineties, in which growth outperformance vs. value was so extreme that many competent value managers were fired (luckily, as it turns out, for those who would become the stalwarts of the hedge fund movement) and at least one organization shut down its value operation entirely.

Then came the bursting of the dot-com bubble, and again a multi-year period of extreme deviation between growth stock and value stock performance, this time in favor of value.

What happens next?  A good question.    At the very least, the distinction will remain, if for no other reason than that pension consulting firms, who are gatekeepers to large corporate pension funds, want it.  It gives them something to monitor–and bill the client for.  In addition, the markets will always be creatures of greed and fear.  On the other hand, one of the traditional hallmarks of the value style is the permanence of assets–whether plant and equipment, brand names or distribution networks–even in badly-run companies.  The demise of the traditional media businesses suggests that in a post-internet world this may no longer be true.   If so, value investors may have to make radical adjustments to what they do.

Which Style Is Better?

I think this ends up being a matter of individual temperament.

There’s lots of academic research that “proves” that buying value stocks works better than buying growth stocks, but I think their conclusions are flawed because they miscategorize growth stocks.  (I must admit stopped looking at these research  papers years ago,because they all did the same thing.)

A value universe is easy to capture using mechanical rules, like: select the low 25% of the S&P 500 by price/book or price/cash flow, or, exclude the stocks with fastest earnings growth.  The rules can either incorporate publicly available earnings estimates or rely on historical data alone.  Growth stocks aren’t so easy to define, since they are by nature stocks where the expectational data will turn out to be wrong.  The data that should be compared are growth managers’ aggregate earnings expectations vs. the market’s earnings expectations.  But those data would be extremely hard to get.

Researchers try to make do by assuming that value stocks and growth stocks are mutually exclusive and that they add up together to make up 100% of the stock market.  They divide a large group of stocks into value and growth categories for study by using mechanical rules  like low price/book to specify  which ones constitute “value” and define “growth” as what’s left over.  Because value and growth aren’t complements, and because there is stuff left over after you count what value and growth managers would buy, this creates problems.

First, the value universe will invariably contain growth stocks, i.e., stocks that will have surprisingly strong earnings performance and which also appear statistically cheap at the outset.  In fact, these are often the best growth stocks, although they will tend to be small in market cap.

Second, the growth universe will doubtless contain stocks that are at the tail end of their high-growth period.  These are issues that no growth investor in the practical world would touch and which will do substantial damage to the holders’  returns when they collapse.  Nevertheless, they are typically defined in studies as being growth stocks.  There is a somewhat analogous group of moribund low price/book companies that one might argue are in a position to do similar damage to value stock returns.  But these are constantly being pruned from the exchanges and exiled to the pink sheets so they disappear before doing their full damage to the value universe.

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