As we’ve discussed before, equity investing strategies come with plenty of variety. A key strategic—even philosophical—dimension of investing style is value vs. growth. In practice of course, these terms are relative, not absolute. Every “value” investor would usually prefer to buy companies that will grow, and a “growth” investor will not be completely insensitive to the estimated stock values. Because of this, value-growth is more of a spectrum than an all-or-nothing polarization. But how do they compare as approaches to investing? In this post, we’ll take a stab at defining value and growth, and crunch some numbers on the strengths and weaknesses of each.
What’s In a Name?
Growth should be intuitive enough—a growth investor will often seek to buy stocks of companies that they expect to grow earnings quickly. It’s easy to see how such an outcome would increase stock prices. If a stock typically trades at 15 times earnings (let’s assume for simplicity that this is predictable and reasonable) and earns $5 per share, the stock price would be $75. However, if earnings grew quickly to eventually be $15 per share, the stock would appreciate to $225. The power of growth to improve business performance (and by extension, the stock price) should be important and obvious.
However, as we’ve mentioned before, stock prices incorporate investor expectations of growth. Investors get caught in a “growth trap” if they end up paying a premium for growth expectations that the company ultimately falls short of. Let’s say the market is anticipating this company to grow earnings to $20 a share—driving the price up to $300 based on the 15x multiple. In this case, you may buy the stock because you see compelling reasons for growth—and you’re right. But if the company only manages to grow to $15/share earnings, the stock price should correct to $225, meaning the stock gets punished despite the company tripling its earnings per share. This isn’t the company’s fault—it’s the markets. To avoid the growth trap, investors should be cognizant of what levels of growth are implied by the current stock price, and think long and hard about how this market consensus compares to their own views.
Value investing, meanwhile, is the pursuit of bargains: stocks with acceptable business performance but without the corresponding market recognition. By buying something that is cheap relative to its earning power, investors can shorten the amount of time before they “get their money back”, assuming the company remains profitable. The measure of attractiveness is often the margin of safety, or the difference between the investor’s estimate of value and the stock price. The investor’s success is less dependent on growth potential than it is on good continued business fundamentals, an attractive entry price, and patience.
But value is not without its weaknesses. To start with, a lot of things are cheap for a reason. A value investor may buy a cheap stock at 10 times earnings, and then lose half. Now the stock is at 5 times earnings—even cheaper, so it’s even more of a value pick, right? This is the “value trap”. Sometimes, things are cheap because the market is inefficient. Other times, they’re cheap because they’re garbage. To avoid the value trap, investors will need to understand the businesses they’re buying and the associated risks.
Fama, French, and the Three Factors
In the 1990s, professors Eugene Fama (University of Chicago) and Kenneth French (Dartmouth) introduced the Fama-French Three-Factor model, an expansion on the basic CAPM model we described here. In this model, stock/portfolio returns were said to be driven by three factors:
- Exposure to the overall market (beta, same as in the CAPM). On average, higher market exposure would increase returns and increase volatility.
- Size. Small stocks would, on average outperform large ones, but with more volatility.
- Style. Value stocks would, on average, outperform growth ones, but with more volatility.
To define value and growth, Fama & French used the Book/Market ratio: the balance sheet equity divided by the market value of equity, or the inverse of Price/Book. A high Book/Market meant the company was cheap, and a value stock. A lower Book/Market meant the company was more expensive, and considered a growth stock.
While more robust than the CAPM, this model has many of the same shortcomings—using volatility as a proxy for risk, for instance. But it gives us a place to start and gives us a hypothesis to test—that value stocks, measured as high Book/Market, should both outperform and have higher volatility relative to growth stocks.
Virtually all the following data is available for free on Professor Kenneth French’s website here. The data essentially “slices” the universe of U.S. stocks based on their Book/Market ratios, and reconstruct these portfolios each year. Returns within each slice can be calculated two ways: value-weighted or equal-weighted.
- Value-weighted means that companies with larger market values are given greater weight according to their market values—so the returns of a large company will have greater weight than those of a small one. For large asset bases with liquidity threshold requirements, this is probably a more relevant measure.
- Equal-weighted means that all companies have the same weight (by definition). This is equivalent to having an equal portfolio allocation to each stock in a slice—which should over-weight small-cap stocks relative to the value-weight. If your portfolio is large enough, this becomes an unrealistic way to measure performance, as you will have to take such large positions that liquidity constraints will prevent rebalancing. As we’ll see, the implications this measurement approach has for returns tells some interesting stories about the interaction between Fama & French’s value and small-cap effects.
Without further ado, let’s make some charts.
Let the Data Judge: Does Cheap Skate By?
To start, we’ll isolate Book/Market analysis by looking at the ten standard decile portfolios, each representing a different degree of value vs. growth. This data covers annual returns from 1927 to 2022. The results give what we’d expect based on the Fama-French model: geometric average returns are higher for the more value-exposed portfolios (especially when equal-weighted), and the standard deviation of annual returns is also higher.
The cumulative annual return for the cheapest decile (decile 10) in the equal-weighted approach is particularly impressive. A 19.5% annualized return over this period could turn an initial $1 in 1926 into $22 million in 2022. The same investment in the equal-weighted growth would only yield $314. For the value-weighted numbers, the difference is less striking, but for every dollar invested, the ultimate value decile still outperforms substantially: $41,164 vs. $3,576 for the ultimate growth—an order of magnitude higher.
When combining our return and volatility numbers to get a risk-adjusted performance, we see that value performs better on that basis when we equal-weight, and worse when we use market-cap weights.
This aside, volatility is merely a proxy for risk. Let’s focus on another meaningful risk: incurring losses. Here’s the number of annual losses incurring for each decile (out of 96 periods), and the average severity of those losses. Again, this comports in line with our theory—mostly. Equal-weighted losses are actually more frequent for the growth deciles, but still less severe than for the value portfolios.
Let’s now abandon the annual horizon. While any time horizon assumption we make is inevitably arbitrary, let’s use 5 years—this is a common holding period for long-term-oriented investors. Plus, it’s more relevant for practical purposes than the 96-year total performance that we started with. We can split our data period into 92 five-year periods (from 1926-31 to 2017-22), to compare performance on that basis.
Over 5-year periods, value-weighted growth losses are more frequent, but equal-weight losses appear evenly distributed—possibly due to failing firms (which would likely become cheap at some point before going bankrupt) being given more weight as opposed to a market value-weight approach.
The critical question, of course, is over five years, which portfolio is likely to outperform? We can get a sense for this by seeing which of the ten deciles performed the best over each of our 92 five-year periods. Here, by either measurement method, value beats growth soundly.
In case you needed further evidence of small-cap’s relationship to value, here’s the average firm size over the time horizon studied for each decile. This could mean that the Fama-French model is faulty, since the value factor and the small-cap factor appear to be present in the same data, making distinctions between the factors difficult. Or perhaps part of the outperformance is simply a “liquidity premium”, as the value decile is compensated for holding smaller stocks that may trade less actively.
I would suggest an alternative interpretation—that this indicates where value is likely to be found. Stocks that are popular due to their growth are likely to have larger market capitalizations simply because of their popularity—Amazon and Tesla are two examples. The goal of value investing is to find something that’s cheap because it’s overlooked, not because it’s poor quality. The smaller a company is, the more likely that retail investors and Wall Street analysts aren’t paying attention—meaning average folks like us have a better chance to have true knowledge advantages—or at least avoid disadvantages.
But Wait, There’s More! Profitability Matters
The data offers opportunity for further analysis. In this case, we now split the market into twenty-five portfolios—five quintiles for value vs. growth, each split into five quintiles based on operating profitability as a percentage of sales. I find this relevant for our purposes, because profitability differences can distort a company’s Book/Market ratio.
As a company loses money, this reduces the book value of its equity, decreasing its Book/Market ratio. In extreme examples, this may make book value negative. Negative or not, this effect will drive a stock toward the growth camp, unless the anticipation of company failure affects the price, in which case the effect may be in the opposite direction. Based on the data on firm size and average losses, I’m guessing that many of the value decile losses are bankruptcies, once the likely of failure is already priced in to make the stock cheap.
To correct for these distortions, I use the profitability dimension to remove some of these troublesome names from the analysis—for each value-growth quintile, I remove the lowest profitability quintile. This should still give enough variance in profitability to reflect the universe as a whole. Besides, any fundamental investor, whether value- or growth-focused, is unlikely to scoop up firms with consistently poor profitability. Therefore, this adjustment should keep its relevance for the opportunity sets we’re facing.
Let’s get into it. We again see a value premium in the long term, and again more pronounced in equal-weight measurements—a 19.6% annualized return. Interestingly, moderately priced stocks appear less volatile than growth.
When looking at risk-adjusted returns, growth appears to underperform, although there appears to be negative marginal efficiency to value relative to the median portfolio. Notably, any value-growth exposure here offered better risk-adjusted returns than the initial deciles—which included the low-profitability firms.
Loss frequency (out of 59 periods) appears close to evenly distributed, with the exception of equal-weight value. Loss magnitudes appear higher than the median for both the growth and value portfolios.
Over a five-year horizon, losses are generally less frequent and severe—possibly due to the removed low-profits effect we mentioned. Here, value appears generally less risky than growth on a value-weighted basis, as well as better-positioned than the median.
Looking at the number of winning portfolios over each of the 55 five-year horizons included shows the same emphatic results. Again, the best five-year results are concentrated in the value end of the spectrum.
Meanwhile, the small-cap/value interaction persists.
So, is all this enough to pronounce value as a superior strategy than growth in the long-term? It gives compelling evidence, but the ultimate decision comes down to time horizons and how you prefer to measure risk.
Russell Takes a Tilt
We don’t have to rely solely on our own data-smithing efforts. FTSE Russell publishes performance for the following stock indices:
- Russell 1000: includes the 1,000 largest companies in the U.S.
- Russell 2000: includes the 2,000 next largest companies (essentially mid- and small-cap companies)
- Each of these indices is accompanied by value and growth variations, taking different weights in the positions to generate a greater style exposure than the general benchmark.
Given this methodology, it makes sense that the Russell value-growth comparisons should be less extreme than the French data suggests. Instead of slicing firms into different groups, Russell simply weights the same basket of firms differently to give a more pronounced value or growth exposure. This method should give a “smoother” comparison.
For the Russell 1000, growth and value have very similar performance, and neither is significantly different from the general index. Growth, in fact, lags the general benchmark, suggesting that growth underperforms the market as a whole. Value ends up being a slight outperformer, and less volatile than growth or the general benchmark.
For the Russell 2000, value begins to pull ahead. But here, things become more interesting. Growth now significantly underperforms the benchmark—possibly due to time-period selection: using a 40-year period that includes the dot-com bubble of the early 2000s and excludes 2020 and on. Growth also shows higher volatility. The benchmark 2000 index actually underperforms the 1000 index, appearing to defy the small-cap effect that Fama and French hypothesized.
The Russell 2000 Value Index, meanwhile, is outperforming the benchmark and growth, with lower volatility than both. This suggests that mid- and small-cap stocks do, in fact, offer more compelling opportunities for value, which makes sense given the relative lack of market attention given to many of those stocks.
What Do You Want to Believe?
The Russell data appears to lend further credence to value as a superior strategy—as does an analysis of the Fama-French data. But investing success is not necessarily dependent on style—it’s possible for investors to outperform their preferred style if they are particularly skilled, whether they choose growth or value. For instance, a particularly clever (or lucky) growth investor could make fortunes by picking the right technology stocks at the right times.
A lot of the ultimate strategy decision comes down to philosophy and temperament. Growth offers a more compelling narrative of what investing is about—seeking tomorrow’s great companies today, and paying a bit of a premium for them, thinking about what technologies and trends will shape the world, and putting a financial projection to accord with these expectations. If they pick the right winners, they will ride the wave to excellent performance. But there’s constant danger of being swept along by the hype and overpaying for growth that won’t be there—or won’t be profitable.
Value is less preoccupied with tomorrow’s big ideas—it is too busy seeking what’s being overlooked today. Companies that are performing well but aren’t getting credit for it by the market are a value investor’s dream. A value investor will likely miss the next big thing—they won’t catch Amazon, Apple, or Google early—but they may find hidden gems across the stock market that can still produce handsome results. This lends itself to a contrarian, road-less-travelled mindset. This sounds appealing to many people, especially given the sensational success of Warren Buffett, value’s most famous modern practitioner—but it requires uncommon patience and discipline.
In your own investing journey, it’s important to bear in mind how your temperament shapes your biases, strengths, and weaknesses, and how your investment philosophy is consistent with your worldview. It’s also helpful in thinking about potential fit with employers—a value mindset may leave you at odds with a growth-focused investment firm, and vice versa.
Unfortunately, some questions do not have clear-cut answers, and require us to search for the answers within ourselves. So, what do you want to believe?