Growth vs. Value – Our Views on These Core Investment Styles

Growth vs. Value – Our Views on These Core Investment Styles

For decades, investors and academics have debated the relative merits of “growth” and “value” investing. Growth has outperformed value recently, but longer-term analysis indicates that value tends to outperform growth. What defines each strategy? Which one should you invest in, and when?

The BDOWA Investment Committee provides a quick primer on growth vs. value and offers BDO’s perspectives on why we believe having exposure to both styles can be beneficial for investors.

What are the defining characteristics of growth and value investing?

As the name suggests, growth stocks are expected to grow faster than the overall market. In most cases, growth companies are in the earlier stages of their lifecycle. Most growth stocks do not pay dividends; instead they reinvest their profits in the business to support continued growth. Growth investors are willing to give up the certainty of a dividend in exchange for the chance to earn greater returns if the stock continues its upward trajectory.

On the other hand, value stocks are viewed as offering a good value given their current price. Active value managers seek out undervalued stocks that, at least in theory, are underpriced because investors have overlooked them in pursuit of growth. There is an implicit assumption that at some point the market will realize that these companies are undervalued and increased demand will push up their prices. Value stocks typically return profits to investors by paying dividends and engaging in share buybacks.

Today, growth stocks tend to be concentrated in the technology sector, whereas value stocks tend to fall in the utilities, consumer staples, and financials sectors.

What key metrics do growth and value investors use to analyze investment opportunities?

Growth investors typically focus on the rate at which a company is able to grow its earnings, as well as the price-to-earnings ratio (or “P/E multiple”), which helps investors analyze the market value of a stock relative to the company’s earnings. Growth investors are often willing to buy stocks trading at high multiples because they think the earnings of the company will increase quickly enough to justify the high price.

Value investors rely most heavily on the price-to-book (P/B) ratio, which measures the market value of a stock relative to the company’s book value, or net asset value of the company. A high P/B ratio (often 2:1 or higher) signals that the value of a firm’s assets as stated on its balance sheet (net of liabilities) exceeds the market value of those assets based on its stock price. If the market is truly undervaluing those assets, investors who buy the stock now are getting those assets cheaply.

Value investors also focus on a company’s dividend yield. But it is important to note that buying stocks based solely on dividend yield can lead to what is known as a “value trap.” In this situation, a stock with a high dividend relative to its price attracts investors, but the company may be struggling and unable to sustain its stated dividend. So, it is important to focus on the quality of the company’s overall position in addition to its stated dividend yield.

It is tempting to create investment “rules” based on these metrics, such as “sell if the P/E multiple on a stock hits X” or “buy if the P/B ratio on a stock goes above Y.” Rules like these are easy to follow, but the approach is far too simplistic. Investors should not rely on any single measure for either growth or value investing.

What market environments do growth stocks vs. value stocks perform well in?

A low interest rate environment tends to favor growth stocks as it lowers the cost of capital for firms that need outside capital to expand. This was the case during the bull market that lasted from the end of the Financial Crisis in 2009 to February 2020. On the other hand, value investing tends to do better when interest rates are rising. For example, low interest rates hurt bank profits, and banks comprise a large portion of value indexes.

Growth stocks tend to outperform when the economy is doing well. Value stocks, such as utilities and consumer staples companies, tend to be more stable and perform better in uncertain economic environments relative to growth stocks. While this is generally true based on historical data, we caution against making any blanket assumptions, as periods like the COVID-19 crisis illustrate that these assumptions don’t always hold true.

In fact, growth stocks outperformed value stocks during the challenging market environment caused by the COVID-19 pandemic in early 2020. This is because tech companies, which dominate growth, benefited from government lockdowns—demand for technology increased massively with more people working from home and social distancing. And while value stocks are often seen a “safety net” in a down economy, the COVID-19 crisis has proven the opposite—many value sectors, such as transportation and lodging, have been devastated.

What is BDO’s growth vs. value investment approach?

At the fund investment level, BDO’s investment committee believes that holding a combination of value, blended (growth and value), and growth funds is currently prudent.

We feel that value stocks are getting more and more interesting in the current environment, as the likelihood that we have entered a lower-growth environment has increased. We don’t, however, turn to value stocks solely because of the income they offer through dividends. With US Treasuries yielding close to 0%, many investors are turning to dividend-paying stocks and MLPs as income-generating alternatives to low-yielding bonds. But there is risk in this strategy. Sometimes, the high dividend yield is due to the fact that the stock price is low for good reason, and could be heading lower—that is the “value trap” mentioned above. We remind investors that if income is their goal, they can create their own income stream from growth stocks (or even value stocks that have appreciated) by selling off a sliver of those holdings to generate cash.

While value stocks appear attractive today, we also recognize that technology will continue to drive growth going forward, so investors should have exposure to that growth. But they should invest in growth in a disciplined way and always avoid chasing returns. As long-term investors, we follow a practice we call “disciplined rebalancing.” This involves trimming back our exposure when any sector experiences a huge run-up and adding to sections of the portfolio when they experience a big drawdown. For example, many individuals spent their pandemic stimulus checks from Congress on technology, but the effect of that activity on stock prices may have already peaked. This helps us to maintain our portfolio targets while “trimming into strength” and “buying into weakness”—another way of saying that this rebalancing strategy is designed to help us sell high and buy low.

In summary, there are merits to both growth and value investing, and we believe that having exposure to both styles of investing is optimal in the current environment. If you would like to learn more about our views on growth vs. value, please reach out to your advisor.

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