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Value Investing is Making a Comeback. Should You Switch from Growth to Value Stocks?

Jun 27, 2022

Value Investing is Making a Comeback. Should You Switch from Growth to Value Stocks?

There are speculations galore that the current market crash in the US has brought an end to a lot of eras.

The era of cheap money and low interest rates being the predominant ones.

Whether this view will turn out to be correct is anybody's guess. But there's another era that is receiving a lot of attention from investors.

The end of the era of growth investing.

You see, for the better part of the last decade, value stocks have been taking it on the chin against their growth counterparts.

In fact, what makes this rivalry interesting is that the decade of 2011 to 2021 was the only one where growth ended up outperforming value.

For all the other decades starting from the 1940s, it's value that has always had an upper hand against growth.

It's not as if growth has never outperformed value. It certainly has. However, it has always passed the baton back to value as far as decadal performances are concerned.

This is why value investors are keen to welcome the return of the old trend with open arms.

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The data over the past few months has been quite encouraging as well. The Vanguard S&P 500 growth stock index is down 29% in 2022.

This means that the growth index has clearly entered a bear market. Its returns over the last one year and last five years read as -16% and 74% respectively.

The Vanguard S&P 500 value index on the other hand is down only 13% in 2022. Its returns over the last one year and five years are -7% and 30% respectively.

Thus, as can be seen, the tables seem to have started turning for the value index.

It may have underperformed its growth counterpart over a 5-year period but holds the aces over a 1-year and year to date periods.

Now, before I go any further, it becomes important for me to point out the difference between growth stocks and value stocks.

The way the S&P Global - the firm behind the creation of these indices - defines it, growth stocks are those with a combination of the highest growth in earnings vis-a-vis the share price, the highest growth in sales, and the best share price performance over a one-year period.

Value stocks, on the other hand, score poorly on the growth parameters. However, they do very well on the price to book, price to earnings, and price to sales ratios.

In other words, stocks with the lowest valuation multiples score the highest on the value dimension.

Ok, so that was quite self-explanatory.

Growth stocks are going through a surge in sales and profits as well as their share prices.

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And value stocks are attractively valued vis-a-vis their current book values and profits.

But what changed in the last 12-18 months that growth stocks have come crashing down whereas value stocks are proving to be resilient? What is it that finally upset the apple cart?

Well, I have a two-word answer: Interest rates.

You see, after years of easy money policies and low interest rates, inflation has started to run amok. So the US Fed has now embarked on a plan of series of interest rate hikes that will take the air out of growth stocks.

Now I'm not saying that rising interest rates do not affect value stocks at all. They certainly do. However, they affect growth stocks more than they affect value stocks.

It's just the simple math of valuation at work here.

Cash flows for growth stocks are more far out in the future than they are for value stocks. So a higher interest rate i.e. a higher denominator, brings down the value of growth stocks more than it does for value stocks.

Thus a rising interest rate environment is a bigger negative for growth stocks than value stocks.

Of course, there are psychological factors at play as well. You see, the reason stock prices fluctuate so much is because they are driven by fear and greed. In other words, they tend to move between overvaluation and undervaluation.

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No prizes for guessing that overvaluation happens more in the case of growth stocks because of the higher growth expectations. And when these expectations are not met, they come down harder than their value counterparts.

I think this is one of the main reasons why value has outperformed growth on most occasions. Since there are low expectations built into value stocks, not only do they fall less than the growth stocks during tough times but also surprise more on the upside during good times.

Well, we have covered a lot of ground here. And if all of this sounds confusing to you, then wait until you hear Warren Buffett.

In his 1992 letter to shareholders, Buffett argued that separating growth and value stocks in this way was not correct. He was of the view that growth and value were not different entities but rather 'joined at the hip'.

Put differently, growth is very much a component of the calculation of value. It's a variable whose importance can range from negligible to enormous. And its impact can be negative as well as positive.

In fact, he even went to the extent of saying that the term 'value investing' itself is redundant.

'What is 'investing' if it's not the act of seeking value at least sufficient to justify the amount paid', argued Buffett.

I think I will have to agree with Buffett here and drop the idea of trying to differentiate stocks based on growth and value.

Our goal should be to calculate the intrinsic value of a stock and buy it at a sufficient discount to its market price.

It shouldn't matter whether the stock is labelled as a growth stock or a value stock.

Thus, the era of growth stocks may certainly be coming to an end and value stocks may outperform going forward.

However, this should not stop you from buying a growth stock where you think the future growth will be more than sufficient to justify the price it is currently quoting at.

Likewise, blindly buying a value stock just because it's trading at a low price to book value or a low PE ratio is also wrong. It may still be trading much higher than its intrinsic value.

Last but not the least, I don't think indices that segregate value and growth stocks exist in India. If it did, I think even here, value would have outperformed growth most of the time.

Nonetheless, as Warren Buffett so eloquently summed up, it isn't really about value vs growth but intrinsic value vs price...and ensuring a big fat margin of safety.

Follow these investing principles and you will be fine.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter

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Equitymaster requests your view! Post a comment on "Value Investing is Making a Comeback. Should You Switch from Growth to Value Stocks?". Click here!

1 Responses to "Value Investing is Making a Comeback. Should You Switch from Growth to Value Stocks?"

Bharat

Jun 28, 2022

The way your describe it is so simple and fantastic. Love reading your articles Rahul ! You are able to explain finest nuances of investing, that too in such plain words, this is amazing.

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Equitymaster requests your view! Post a comment on "Value Investing is Making a Comeback. Should You Switch from Growth to Value Stocks?". Click here!