Investing in 2018: Growth vs. Value

Investing in 2018: Growth vs. Value

 

Growth or value — what’s your style?  The debate surrounding which strategy is superior has raged on for ages.  For a quick refresher, growth investors look for stocks that will grow at a high rate for a relatively short period of time. Value investors look for stocks that are currently undervalued and are expected to increase to their true value over a longer time horizon.

Companies like Facebook, Amazon, Netflix, and Google (AKA, the FANG stocks) fall into the growth category, and paced the market in 2017 with an exceptionally strong year.  Looking ahead, what should we expect in 2018?  Should we favor growth strategies, given the momentum of the FANG stocks?  Or should we expect value shares to outperform?

 

Growth Fundamentals

First, a better primer on growth investing.  Growth investors seek companies that show consistent earnings and sales growth, usually 25% or more each year, for a three- to five-year period. Typically, the companies represented by these stocks are in rapidly expanding industries; they offer proprietary niche products or services; or they have well-known brand names, strong finances, and top management. They have superior profit margins and generally high (over 15%) return on shareholder equity. They seldom pay dividends, preferring, instead, to plow earnings back into the company.

Two key indicators of growth stocks are share price and earnings. Generally, the earnings growth rate is the more important of the two indicators for growth stock investors. It is the rate at which profits grow from year to year. Generally, growth stocks have an earnings growth rate over 25%. Consistency is also important. The market will not place as high a value on a company whose profits are up 40% one year and down 10% the next, as on a company that grows 25% year after year.

Another key indicator for growth investors is stock price relative to the earnings, or the price to earnings (P/E) ratio. The P/E ratio, which is determined by dividing the current share price by the earnings estimate, represents what the market is willing to pay for a share of the company’s earning power. Although a growth investor may be willing to buy a company sporting a high P/E ratio, some relative guidelines should also be considered. Ideally, the P/E should be lower than the earnings growth rate.  For example, an acceptable opportunity may be a company with a growth rate of 45% selling at a P/E of 30. It is also a good idea to look at a stock’s P/E in relation to the average P/E for its industry, and relative to the market as a whole.

 

Value Fundamentals

Unlike growth investors, value investors typically buy stock that has a P/E ratio substantially below that of the general market, the relevant industry, and the earnings growth rate. Value investors look for companies that are cheap relative to the “book value” of its equity.  Book value is the difference between a company’s assets and its liabilities. It is theoretically the value of the portion of the company represented by a share of stock. Book value divided by the current market price, or price to book, shows the multiple that the market is willing to pay for a portion of the company’s assets.

Generous dividend payments, or a high yield, is also important to value investors.  Dividends can account for significant portion of a stock's long-run total return, so value investors often look for higher yielding opportunities.  Additionally, value investors expect the price of stocks to rise to their true "intrinsic" values, which are predetermined targets. When the target, or the “appropriate” value is reached, a value investor may sell that stock and look for another selling at a discount.

 

Growth vs. Value: Which is Superior?

So if growth stocks had better returns in 2017 than value stocks, what should we expect for 2018?  Should we load up on shares of Facebook, Amazon, Netflix and Google?

The short answer is no, I wouldn't recommend it.  Our philosophy at Three Oaks Capital is not to predict the future.  Instead, we use data and research based on empirical evidence to guide our decision making.  And based on contemporary research, value tends to do a little better than growth over the long term.

Take the Russell 1000 index, for example.  Over the last 37 years, the average annual return of the Russell 1000 index was 11.74%.  And when we split that into its value and growth components, the Russell 1000 growth index returned 11.05% per year, while the Russell 1000 value index returned 12.06%.

Remember, these are only the averages.  In most years returns will either far above or far below these long run averages.  But fact remains that if you'd invested in value stocks consistently over the last 37 years, you'd be better off than if you'd invested in growth.

That doesn't mean that growth won't outperform value again in 2018, though.  While we can draw well founded conclusions to aid our investing over longer periods of time, shorter periods of time are just "noise".  Because of that, it doesn't surprise me that growth shares outperformed value in 2017.  I wouldn't be surprised if they continued to do so in 2018, or even for the next five years! 

But when we extend the time horizon 10 years, 20 years, or longer, the amount of data grows enough to give us confidence that the outcome will resemble its long term trend.  It's the law of large numbers.  There's enough data to smooth out the short term volatility and noise.

This isn't speculation or conjecture, it's just math and statistics.  That's why I'll always say that I can't tell you what the market will do over the next 2 to 5 years, but I can absolutely tell you what the market will do over the next 20.  And over the next 20 years, I expect value to outperform growth.