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The Growth vs. Value Debate — Depends on the Holding Period

By Jim Fink on April 3, 2012

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It’s common wisdom that value stocks (i.e., stocks sporting a low valuation multiple, such as price-to-book or price-to-earnings) outperform growth stocks (i.e., stocks sporting a high valuation multiple) over the long run.

In fact, I repeated this maxim in my previous article entitled So, You Want to Be a Value Investor? – Think Businesslike, where I summarized the findings of an Ibbotson Associates study showing that value stocks outperformed growth stocks by an average of several percentage points per year over a multi-decade period. Other studies by: (1) Fama and French; (2) Lakonishok, Shleiffer, and Vishny; and (3) The Brandes Institute reached similar conclusions.

It’s More Complicated

Statistics can be tricky. As humorist Evan Esar once quipped, statistics is the “only science that enables different experts using the same figures to draw different conclusions.” And this value vs. growth debate is a perfect example.

Reformulate vs. Buy-and-Hold makes All the Difference

Here’s the deal: value stocks outperform growth stocks over long periods of time only if you reformulate the portfolio of stocks on a periodic basis. These studies do not claim that a long-term buy-and-hold portfolio of the same value stocks outperform a buy-and-hold portfolio of the same growth stocks over decades. For example, take a look at the Ibbotson study’s methodology:

Portfolios were formed at June-end of each year, and value-weighted monthly returns were calculated from July to the following June.

Similarly, for the Fama/French methodology:the portfolios are formed at the end of each calendar year from 1974 to 1994, and returns are calculated for the following year.” The Lakonishok study had a bit longer holding period of five years, but these authors noted: “The superior returns to value strategies persist for at least 5 years (perhaps with some petering out toward years 4 and 5).”

There you have it. If you are the type of investor who likes to buy-and-hold stocks for decades, these value studies are worthless, despite the banner headlines of multi-decade value outperformance. Only if you are willing to trade in and out of stocks on a yearly or slightly longer periodic basis, can a simple strategy of buying cheap stocks outperform over the long term.

Buy-and-Hold Growth Outperforms!

So, have any studies been done to determine which style of stocks outperform for the typical long-term buy-and-hold investor? Yes, and the results are the exact opposite of the previously mentioned studies. For holding periods of as little as 8 years, academic studies have determined that a portfolio of growth companies outperforms a portfolio of value stocks.  For example, a 2003 study by University of North Dakota finance professor Nancy Beneda looked at an 18-year sample period between 1983 and 2001. Her conclusion:

To truly assess the performance of growth stocks, a long-term horizon assuming a buy-and-hold strategy must be examined. The results indicate that over the first five years or so after portfolio formation, the performance of the growth stocks lags behind that of the value stocks. However, after the seventh or eighth year, the value indexes for the growth stock portfolios, in general, pass up that for the value stocks.

A 2005 study from Harvard concludes the same thing:

We find that on average equity-only investors with short horizons optimally choose portfolios heavily tilted toward value and away from growth. However, the optimal allocation to value decreases dramatically, and correspondingly the optimal allocation to growth increases, for investors with longer horizons.

The question remains why buy-and-hold growth stocks should outperform buy-and-hold value stocks over the long term. The best way to answer this is to explain the beneficial attributes of growth stocks.

What is a Growth Stock?

A growth stock is a money machine that generates substantial – and sustainable — positive cash flow and whose revenues and earnings are expected to increase at a faster rate than the average company. A growth company typically has some sort of competitive advantage that allows it to fend off competitors and keep the lion’s share of business to itself. It also has many different investment opportunities (or a few large opportunities) that promise to generate high returns. These high-return opportunities justify retaining most if not all of the growth company’s earnings and not paying them out to shareholders in dividends. 

Growth Stocks and Interest Rates

By definition, most of the value of a growth company comes from its future earnings, not from its current asset value. Consequently, a company’s value is significantly impacted by changes in the interest rate used to discount future earnings. The higher the time value of money, the more future earnings are discounted and the lower their net present value.  The good news is that interest rates are mean reverting, which means they ebb and flow over time and average out in the long run, which reduces risk for the long-term buy-and-hold-investor. 

Compounded Earnings Growth Deserves a Premium Price

Growth stocks are not priced cheaply because they possess so many favorable qualities (e.g., consistently growing earnings, competitive advantages, solid and stable business prospects).  Consequently, they trade at higher multiples of earnings and book value than other stocks. But don’t let these higher prices dissuade you from investing in them!  As the incomparable Warren Buffett likes to say: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Wonderful companies quickly outgrow their relatively high valuations and turn out to be bargains. Peter Lynch, the former manager of the Fidelity Magellan fund and another great investor, put it this way in his book One Up on Wall Street:

A 20-percent grower selling at 20 times earnings is (a p/e of 20) is a much better buy than a 10-percent grower selling at 10 times earnings (a p/e of 10). Look at the widening gap in earnings between a 20-percent grower and a 10-percent grower that both start off with the same $1 in earnings:

 

Company A

(20% earnings growth)

Company B

(10% earnings growth)

Base Year

$1.00 a share

$1.00 a share

Year 1

$1.20

$1.10

Year 2

$1.44

$1.21

Year 3

$1.73

$1.33

Year 4

$2.07

$1.46

Year 5

$2.49

$1.61

Year 7

$3.58

$1.95

Year 10

$6.19

$2.59

 

Company A starts off selling for $20 a share (20 times earnings of $1), and by the end it sells for $123.80 (20 times earnings of $6.19), a gain of 619%. Company B starts out selling for $10 a share (10 times earnings of $1) and ends up selling for $25.90 (10 times earnings of $2.59), a gain of only 259%. Company A – the growth stock – is the clear winner despite starting off twice as pricey. It’s all based on the simple arithmetic of compounded earnings growth. You get what you pay for!

Price is Important – Don’t Overpay

Note: Mr. Lynch warns that it’s virtually impossible for a company to grow its earnings by 25% or more over any extended period of time, so don’t be willing to pay “any price” even for a great growth stock. According to Lynch, one way not to overpay is to focus on boring, nongrowth industries that most investors ignore.  To him, ideal investments are companies that are “moderately fast growers (20 to 25 percent) in nongrowth industries.”

But in high-growth industries, how high a price is too high? Wharton finance professor Jeremy Siegel, in his book Stocks for the Long Run, studied the stock performance of the “Nifty Fifty” large-cap growth stocks from the market peak in 1972 until 2001, and concluded that a P/E of 40 times was around the highest justifiable price to pay for a good growth stock. 

Tried-and-True Growth Is Less Risky Than Cheap-but-Weak Value

The rationale for growth stock outperformance is the difference in risk factors between growth and value. The main risk factor for growth stocks is interest rates, which even out over the long run, thereby minimizing the risk. In contrast, the main risk factor for value stocks is business risk – their future cash flows diminish because of competitive threats, a deteriorating market, or too much leverage in their capital structure.

Business risk is not mean reverting and could get worse in the long run. Over the short-term, cheap stocks have a tendency to bounce back strongly as investors worst fears tend not to materialize. If you rebalance a value-stock portfolio annually, this bounce-back phenomenon of the cheapest stocks outweighs the inherent business flaws that caused the stock to become cheap in the first place. But over the long-term, the fundamentally weak business model of most value stocks reasserts itself and causes mediocre long-term performance.

This is one reason why University of Chicago finance professor Eugene Fama and other efficient market theorists have written that high-priced growth stocks are less risky than low-priced value stocks in the long run (in fact, that’s why the growth stocks are higher priced to begin with!).

Bottom Line

There you have it. To reformulate your stock portfolio or not reformulate, that is the question. For those who like to trade stocks on an annual basis, go with value stocks. For you buy-and-hold types, go with growth stocks.

Editor’s note: See our growth stocks report to uncover 5 free growth stock picks.  

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Stock Talk

  1. avatar
    Karl Gauvin Reply May 15, 2012 at 2:13 PM EDT

    So Buy and Hold Growth Outperformed Buy and Hold Value strategy. Ok, that make sense, but does Buy and Hold Growth outperformed Periodic Basis Value strategy?

  2. avatar
    L. Keith Reply April 8, 2012 at 9:49 PM EDT

    Well stated

  3. avatar
    Wells Wagner Reply April 7, 2012 at 8:05 AM EDT

    What would you say are good growth stocks at this time (April 2012) knowing that interest may not change for two years?
    Thank you.