The age old debate that has entertained investors around the campfire for the last 100 years has been, “What’s a better investment approach: Value or Growth?”. To have a constructive debate, we first must agree on what these terms mean as in our experience investors often mix up the terminology we use to describe these different approaches.
What is value investing?
Value investors search for investments that are trading below their ‘true worth’ relative to the company’s current assets, revenue or profits. They are focused on the ‘here and now’. These investors avoid companies trading above their ‘tangible’ or physical value. Typically (but not always), value stocks will be mature companies that end up being quite sensitive to economic cycles (recession/expansions). Mispricing in these companies is greatest at the extremes when you are at the beginning or end of an economic cycle (e.g. expensive or cheap).
What is growth investing?
Growth investors search for investments that are undervalued relative to their future assets, revenue or profits. They are focused on the ‘what lies ahead’. If a company trades over its current tangible asset-backed valuation, this is not a deal-breaker as long as the company continues to meet key ‘milestones’. Typically, mispricing in these companies is greatest at the extremes of too much enthusiasm or their potential is under appreciated.
There is one more complexity to growth investing that savvy investors consider. Earnings growth is rarely linear. Amazon, one of the largest companies in the world, is a great example of how growth is typically not linear. At every point in Amazon’s post-IPO life, a value investor would have said the company was overpriced, anxiously awaiting for a cheaper valuation that never transpired. The growth investor however saw opportunity two, five and 10 years out and obviously did quite well.
Being ‘growth or value’ is not a risk profile
One can be a growth investor and be conservative in nature or a value investor and be quite aggressive. How you value a company should not be confused with your risk appetite or risk profile. Your risk profile should be influenced instead by your liquidity requirements, volatility appetite, duration or time frame objectives at the portfolio’s asset allocation level, not the stock selection level – which is where implementing a Growth or Value approach comes into play.
Which approach is most profitable?
Although there is never a hard or fast rule, in our experience if one applies the correct methodology to the appropriate approach, both can be equally profitable. However, the investor needs to be clear which trading methodology is being applied - “Are you holding or are you trading?”
Value investors are able to more easily identify mispricing in stocks based on today’s facts. Cyclical or economic factors which are known in present time make trading mispricing quite profitable.
- Higher Activity Levels
Best if you are more “Active” (daily, weekly or monthly) trader.
- Shorter Outlook
Although long term earnings quality may still be important, this investor does not put as much weight in the long term ‘potential’ of the company.
- Holding periods
Typically shorter than growth investors.
Growth investors are less interested in short term economic factors and look beyond 2 years to identify ‘inevitable’ value or secular trends. To be clear, Growth is not defined by the amount of speculation imbedded in the company but by the quality of the earnings growth or future profitability of a company. For example, Microsoft, which is one of the largest most profitable companies in the world, is still considered a growth stock.
- Lower Activity Levels
If your investment time horizon is more than two or three years – this approach is a great fit.
- Longer Outlook
Although they may try to avoid overpaying for an asset, this investor does not put as much weight in the company’s current valuation.
- Holding periods
Typically longer than value investors.
Using history as a guide
Although the last 20 years would materially favour long term growth investors, there are plenty of examples where both approaches have been extremely successful.
The key is to understanding that:
- If you are a ‘buy and hold’ investor, this doesn’t mean by default you are a value investor; and
- Just because you ‘trade your portfolio’ frequently doesn’t mean you are a growth investor.
However, by matching the appropriate strategy to the appropriate execution, your chances of success are significantly higher.