A Practitioner’s Guide to Style Investing (2): Value and Growth

Style investing can be a rather dry subject full of arcane metrics like P/E-to-Growth, Price-Book threshold screens and five-year normalized Free Cash Flows. Personally, I prefer to talk about handbags. [Technorati code 3CR4DPF7BDXP ]

There are two types of handbag shoppers in the world (okay, there are many more than that, but two will suffice for this illustration). One is the intrepid bargain-hunter who searches high and low for something of high quality and a low price relative to that quality. You’ll find her in Filene’s Basement or nondescript boutiques with racks and bins of bags of various (sometimes dubious) levels of quality, rubbing leather straps with her fingers, holding a bag up at 15 different angles to examine the stitching, turning it inside out to parse the details of the interior applications, rejecting 20 candidates before settling on one. Given an opportunity to do a little price bargaining with the shopkeeper she will do that too.

That type, in short, is a value investor.

Exhibit B: This shopper can be found in the ritzy, high-end stores that line the streets of Beverly Hills, New York’s Upper East Side or London’s Knightsbridge. But she’s not just a wannabee brand-a-holic for whom any old Coach or Fendi or Kate Spade will do. She has (or thinks she has) a keen sense of what the “must-have” bag of the next season is going to be, and she wants that bag at any price because it can only become more valuable as it becomes ever more feverishly sought-after.

Therein lies the archetypal growth investor.

Value and growth investing are simply two different philosophies driving strategies for profitable investing. A value investor starts by creating a universe of stocks perceived to be undervalued relative to the market. The “Price-Book threshold screen” we mentioned earlier is one way to accomplish this: start with all stocks whose price per share is low relative to reported book value per share. Book value is what is left on the company’s balance sheets when liabilities are subtracted from assets.

The next tool in the value investor’s arsenal is a mechanism for picking out from this universe stocks that are worth more than their sticker price as opposed to the ones whose low valuations simply reflect low quality. One school of value investor is the “fundamentalist” who combs over every detail of a company’s financial statements, business strategy, pending sales contracts and anything else he can get his hands on to assess whether its fair value is lower than the market value indicated by the stock price. Here’s where something like “normalized Free Cash Flows” come into play: the value investor creates a model with assumptions sustainable cash flows, figures out what those cash flows represent in present value terms, and compares that result to the current share price to determine whether a value play exists.

A variation of the fundamentalist is the deep-value investor who applies similar techniques but has a predilection for really distressed situations where the market seems to have written off the stock. The deep-value type believes that not all distressed situations are lost causes and hopes to snap up the survivors at pennies on the dollar. Finally, a third distinct type of value investor is the contrarian, whose world view can largely be summed up as “the conventional wisdom is wrong and I am right”. If the herd is running in one direction the contrarian is off by herself looking for overlooked opportunities.

The mentality of the growth investor is quite different. Just like the shopper in her quest for the “it” bag, the growth investor’s perpetual dream is to spot the next Apple or Google before anyone else does, in which case it is likely that the price you actually pay won’t really matter all that much relative to the rewards you will enjoy. Of course there has to be some kind of a quantitative discipline to spot these opportunities. Price/Earnings to Growth (PEG) is one metric beloved of many growth investors. PEG says that a stock’s P/E ratio, itself a measure of how cheap or expensive a stock is compared to its peers, is more meaningful in the context of its prospects for earnings growth. A stock with a P/E of 20 may be considered expensive if the average P/E for the market is 15, but if the stock has a 5-year consensus earnings forecast of 15% annual growth and the average market growth is expected to be 3% then the growth investor would argue it makes sense to buy the stock.

A variation of growth is Growth at a Reasonable Price (GARP), which tries to combine some value investing techniques into a growth model. In our world of handbag shoppers the GARP investor hopes to find one of those hot-ticket bags from a store offering temporary promotional discounts.

How do the numbers stack up for growth and value? Below we reproduce the chart we introduced last week showing multi-period total returns for different styles as measured by the Russell indexes.

The Russell 3000 is a broad-cap index and so provides a more distinct comparison of value and growth. Over a 16 year period to 2010 the Russell 3000 Value Index outperformed its growth counterpart by a bit under 2% on an average annual basis. For the ten year period the difference was greater – you earned almost 7% more (annually) from choosing value over growth. On the other hand the value index was much worse than the growth index for the three year measure. This is largely because the value index contains a disproportionate number of financial services stocks, which were all hit hard by the Wall Street meltdown in 2008.

Longer time horizons tend to be a more accurate gauge of value differences as they reflect multiple market cycles. The outperformance indicated here by value stocks over the long term is not anomalous: extensive studies by academics and market practitioners over time have demonstrated fairly compelling evidence that on average value stocks tend to outperform growth stocks over long periods of time. That is on its face surprising: if you can earn 2% or more in average annual returns over time from investing in value stocks then why wouldn’t everyone do so? And if that much value is really being left on the table then why wouldn’t it be “arbitraged away” in the parlance of financial markets? Aren’t markets supposed to be rational? These are all important questions, and we will be coming back to them in the next post.