Value or growth strategy?

Growth investors are usually willing to overpay for current earnings because they estimate that future earnings potential is so much greater.

They are the world’s investment optimists.

Value investors, conversely, are drawn to pessimism, hoping to buy a company at a discount because of all the bad news surrounding its current and future earnings.

So, why has growth done so well and value so poorly?

Although many growth investors deserve credit for excellent stock selection, there is an argument that low interest rates have helped their cause.

Because growth investors place an emphasis on future earnings, low interest rates mean the value of future money is far higher, inflating today’s earnings multiple.

Value investors, by contrast, benefit relative to growth managers when the value of future money is low because they are far more focused on the present.

Higher interest rates and inflation, the argument goes, should therefore be supportive to value as a style.

What are the main arguments against value investing?   

There are broadly three. First is the one we discussed above; rates stay lower for longer, creating permanently higher values of future cash flows, justifying higher price-to-earnings ratios on predicted earnings and pushing up prices of growth stocks, causing value to lag.

It follows that growth investing then becomes a bet on interest rate policy.

Even if this argument has merit, we tend to disagree with making such large investment decisions based on a single binary macro view (which is notoriously tough to predict).

The second reason is that pundits suggest value investing requires inflation to do well, and a flat US yield curve suggests inflation may be unlikely. 

There are probably two parts to this argument.

First, today value investors (especially in the UK) are often seen as owners of cyclical companies like banks, oil majors, miners and retail companies.

And inflation is usually very healthy for these companies.

Second, unlike growth investors, value investors seek many of their gains today, rather than far out in the future and we have mentioned how this theoretically leads investors to prefer value strategies (over growth) in an inflationary environment.

But, how does the evidence stack up when empirically tested?

We used the value factor derived from the Fama-French model for US stocks going back to 1926 and evaluated whether there was a positive correlation between inflation and value outperforming.

Our findings on the relationship between inflation and value investing outperformance are summarised in the table below.

This puts forward strong evidence that there is no strong correlation, positive or negative, to value investing outperforming in inflationary and deflationary environments.

The third argument against value investing is that industries are being permanently disrupted by companies like the tech giants in effect inferring that mean reversion of earnings and returns on equity are less reliable now. Is this valid? 

The short answer is probably, but with a caveat.

Microsoft, Facebook, Alphabet (Google), Amazon, Netflix, Uber, AirBnB, Tesla et al have significantly changed consumer behaviour and are materially impacting sectors like technology, retail, media, press, transport, leisure and others.

Are value managers therefore more prone to value traps now? Yes, in theory.

Although we do not favour value over growth, we do still find it tough to understand why value investing is so unloved.

If it is for any of the three reasons above, the evidence seems to counter much of it.

Rory Maguire is managing director of Fundhouse