Why commonly-cited reasons fail to explain value vs. growth debate

Summary

  • Main reasons cited to explain whether value investing will outperform growth investing are explored
  • These reasons are not enough to fully explain the problem
  • What we need in inclusion of more factors to better understand the issue

Value investing is a tried and proven investing technique that has outperformed the market for decades. Yet it is a well-known fact that value investing has not done well in the last ten years while growth investing has brought about much higher returns. This phenomenon has given rise to many articles on whether it is now time to switch back to value investing.

Value stocks are stocks that are trading at low valuations e.g. low PE, Price to Sales, Price to Book, etc. Growth stocks are stocks that exhibit strong earnings growth potential and therefore are also trading at high valuations. These are the commonly-cited reasons as to why value strategy should outperform from now onwards.

  • The valuation gap between value and growth stocks are wide by historical standards and therefore should narrow
  • Previous cycles of growth outperforming value average x months and should reverse after that
  • Value outperforms growth at certain stages of the stock market or economic cycle and we should make the switch depending on which stage we are entering into

The reason why these reasons do not explain why one strategy outperforms the other is that they are incomplete. In order to more fully understand the problem, there are other pertinent factors that need to be explored.

The price of  both value and growth stocks at the end of one year is their PEs multiplied by earnings in one year’s time. Therefore, we need to consider both the movements of PE and earnings. It has been argued that since the valuation gap between value and growth stocks are at a high level compared to historical standards, it is time for the gap to narrow.

It is true that whether PE of a stock moves up or down depends on how it has deviated from its average historical PE. A value stock’s low PE may move up if it is too low compared to its historical average and a growth stock’s PE may move down if it is too high compared to its historical average. Therefore, the valuation gap between value and growth stocks can at least explain this part of the problem.

But reversion to the mean is not the only reason to cause a stock’s PE to move.  Finance theory tells us that PE of a stock = 1 / (k – g) where “k” is the required rate of return. The higher the risks associated with the stock (e.g. financial condition or earnings quality is poor), the higher “k” would be and the lower PE would be. “g”refers to the growth expectations of the stock. If investors expects the growth prospects of the stock to improve, “g” will be higher and so will PE. If you want to see real-life examples of how these factors affect PEs please read this article.

These additional factors (i.e. financial condition, earnings quality and growth) that determine how PEs will behave are company-specific. In order to determine how PEs of a group of value stocks will behave, we need to do a bottom-up analysis to determine how the PE of each stock will behave and then aggregate the effects.

Furthermore, the price of a stock depends not only on its future PE but also on its future earnings. Therefore, an explanation that relies on the valuation gap alone misses out on this important piece of information. What we need is to do a bottom-up estimation of the earnings of value and growth companies before we can determine the future earnings of the value and growth sector. A macro approach to determine the relative growth rate of value and growth stocks based on the stage of the economic cycle is inadequate.

Go here to see an example of bottom-up analysis to see if the Russell 1000 value stocks will outperform the Russell 1000 growth stocks.