The distinction between growth and value investing is one that has come from America. A decade ago i...
The distinction between growth and value investing is one that has come from America. A decade ago in the UK, distinctions were more often drawn between growth and income. However, in the growth-led tech boom and the long bear market that followed, the ideas were widely taken up on this side of the Atlantic too.
What's the difference?
Growth investing focuses on finding companies with the potential for above-average earnings growth. This could be because they are in a high-growth area or because barriers to entry in their market give them a competitive advantage. Regardless of the economic conditions, growth companies will seek to grow their earnings aggressively.
Value investing is about identifying stocks that are trading below their fundamental value, probably because they are out of favour with the market. This could simply be because their area of business is unloved, or because there have been problems within the business, such as disappointing earnings, negative publicity or legal problems.
How is growth and value measured?
When valuing a company, the primary measures that fund managers and analysts use are the price/earnings or P/E ratio (the price of a share divided by the current year's earnings per share) and the price-to-book value (the share price divided by the book value per share). Value companies will tend to trade on below-market multiples by both of these measures, whereas growth companies are relatively highly priced in relation to their net assets, and thus their ratios will tend to be above the average for the market.
Features of growth and value stocks
Although they may be priced at a premium to the broader market, growth companies are less sensitive to economic conditions and usually have a good record of growing earnings, which, although it is no guarantee of future performance, will make investors feel happier about paying a little extra. The bargain prices of value stocks, based as they often are on company-specific problems, mean value stocks can be riskier than the broader market, but if they do turn the corner and begin performing to their potential again, the upside can be significant.
Is one way better than the other?
At different times, growth or value might perform better. Value companies tend to be more cyclical, with whole areas of the market falling out of favour in certain economic conditions. Yet in a bear market, all stocks tend to be marked down, and it is often the growth stocks that are hit hardest as pessimistic investors refuse to pay a premium for earnings growth they fear may not materialise. The bear market that followed the dotcom bubble illustrates this clearly: the growth of these stocks in the years of the boom had been phenomenal but was arguably completely divorced from fundamentals, as in many cases the companies had yet to make a profit and were valued according to the new paradigm theory that any internet-based business model was bound to succeed. (The idea of growth at a reasonable price came up in the aftermath of this, probably in recognition that the growth-at-any-price attitude that had driven up dotcom share prices to hundreds of dollars was not prudent.) During the boom years, defensive stocks such as tobacco and mining fell out of favour, providing opportunities for value investors. However, for value investing to succeed, there needs to be a catalyst for change, otherwise today's value opportunity might just turn into tomorrow's corporate failure.
What sort of catalysts are these?
Often it can be something as simple as over-pessimism. Analysts are often guilty of herding behaviour, talking up stocks that are in favour and then dropping them like hot potatoes at the first sign of trouble. (The recent Northern Rock crisis is a prime example of this: in early 2007 the shares were trading at around £12 but were still rated a buy by most sell-side analysts; at £1.50 there were few buy recommendations.) If the fundamentals of the company are better than perceptions suggest, the analysts will eventually come round and the market will start buying again, providing good profit opportunities for value investors who got in early. The catalyst could also be a change of management or a takeover approach.
Finding a happy medium
Being 100% in growth or 100% in value can be as risky as trying to time the market. There will always be times when one style is in the ascendant. Fund managers who brand themselves growth or value will suffer periods of underperformance when their style is out of favour - but as equity investment is a long-term exercise, these should iron out over time. For most investors it is sensible to have a mix of styles, either by blending funds or using pragmatic managers who can move around the market according to where they see opportunities. Achieving such a happy medium means investors will have a better chance of good performance in all economic conditions, regardless of which style is in favour.