A Last Gasp for Growth?

A Last Gasp for Growth?

Why It Pays to Remember

In this article, Dr Adrian Saville, CIO of Cannon Asset Managers, examines the long-term performance of growth stocks relative to value stocks and concludes that value is the place to be.

Value versus Growth: The Evidence

Active investment managers belong to one of two camps: the value school or the growth school.  Each has its strengths and weakness. 

The growth philosophy has powerful upside available where great companies are identified early, but it also runs the risk that blue sky potential does not materialise or that high growth environments disappear faster than anticipated.

By contrast, the value philosophy benefits from its lack of reliance on forecasting – something that investors are hopelessly bad at. However, a weakness might stem from value remaining trapped because catalysts do not materialise, or from management failing to recover underperforming assets.

Significantly, because value investing places emphasis on known elements, it means that downside risk tends to be much smaller than in the case of growth investing.

The bold differences between the two philosophies mean that at different times one will dominate the other. We see evidence of this in the South African market:

·          Value stocks outpaced growth stocks by a wide margin in 2001 as the latter fell from grace with the collapse of the technology-media-telecommunications bubble.

·          However in 2002, as South African equities struggled under the bear market environment, growth stocks outperformed value stocks handsomely.

·          Then, over the next three years, to the end of 2005, value stocks again outpaced growth stocks. 

In short, style success rotates though time.  Most recently, growth investing has had the upper hand.  Since the middle of 2007, growth stocks have outperformed value stocks by about 9%.

Value has stood the test of time

Value has proved the superior philosophy through time and across geographies.  The compelling 1998 study conducted by Fama and French showed that, over the 20 years 1975-1995, value stocks outperformed growth stocks in all of the world’s major markets by an average of 5.8% p.a.  Further, value stocks beat the market by an average of 2.9% p.a. 

The case is no different in South Africa: value stocks delivered an average annual return some 10.2% ahead of growth stocks from 2000 to end 2007; and the performances of value against growth in earlier decades reinforces this result.

Sharply different from growth investing, value investing is conservative; it buys what is ‘safe and cheap’. ‘Safe’ refers to survival of the business, ‘cheap’ to a stock price that is significantly below what a competitor or private equity fund would be prepared to pay.

Value stocks will tend to have a far more volatile earnings pattern, but taking a single year’s earnings seriously remains one of the biggest mistakes in financial analysis. Recall Buffet’s observation on this score: “I’ll take a bumpy 15 percent over a smooth 10 percent any day.”

Value investors should always examine a set of factors that emphasise value as well as quality and investment return potential.  The combination used in Cannon Asset Managers’ process includes the price-earnings ratio, price-book ratio, price-sales ratio, a metric called the F Score (which emphasises liquidity and solvency) and dividend yield (identified by Graham and Dodd, the fathers of financial analysis, as having a greater impact on market value than earnings retained).

A word of warning though: value can remain value for a long time because momentum investors often continue selling long after the stock has already fallen to below ‘fair’ value. Value investing requires patience.

While growth stocks may have shown strong performance recently, investors should resist their seduction: they are unlikely to remain top performers in the long term.