Stock market participants often argue whether neglected value stocks or popular growth stocks are more lucrative as in investment target. Yet this dogmatic thinking makes little sense. A dual strategy from a combination of reasonable relative valuation and existing stock price momentum is more efficient.
As with athletes, for participants on the stock markets it’s all about winning. Mostly investors feel like winners when they outperform the market as a whole. Also as in sports, various strategies are available to reach that goal.
However, the options are rarely used by an investor in a variable way. Instead, one specific procedure is always stubbornly practiced. In the toolbox, for example, value- and growth-approaches can be found. The latter growth stocks lure with above-average growth prospects, whereas value stocks score with a low valuation at criteria such as price-earnings ratio, price to cash flow, price-to-book, price-to-sales ratio or dividend yield. As so often on the stock market, the followers of these two groups face off irreconcilably since they believe strongly in the superiority of their own approach.
In recent years, the growth-believers had the edge in that competition, thanks to significantly better performance. This result can be explained by the fact that in the prevailing low-growth area, growth stocks are scarce and investors pounce on the few remaining representatives of this type.
This happens more so as the following is considered: The earnings growth rate over the next five-year period predicted by analysts for U.S. value stocks has flattened out over the course of the years to only 6.7 percent per year currently. Growth stocks, in contrast, according to data provided by Yardeni Research, come with an earnings growth rate of 13.2 percent per annum, which was relatively stable over time.
With regard to the estimated profit margins, the balance of power stands at 8.7 percent compared to 13.8 percent. An edge, value (15.0) compared to growth (18.5) is not able to offset with the help of a lower price-earnings ratio.
But the value-followers do not give up only because of that. They find hope in the results of studies that show over very long periods, superior performance results for value-stocks. One of these studies, for example, reveals for the time period from 1913 to 2015, a bigger gain of 4.8 percent on average for value stocks compared to growth stocks. After years of relative weakness, some experts consider a change of guard again as possible. The signal for a change could bring a U.S. rate hike. Among the advocates of this thesis is Barclays analyst Ian Scott, who says: “History suggests that shifts in monetary cycles can have profound effects on stock market leadership – especially styles – where we would expect to see a rotation in favor of ‘value.’” In any case, an outperformance of value has been a characteristic of past tightening cycles, according to Barclays.
Is history repeating itself?
At the same time, the youngest performance advantage of growth can be explained retrospectively, since this phase was accompanied by falling bond yields. This interaction is confirmed in a study by the analysts of JP Morgan. The analysts write about a better performance of growth compared to value in the wake of recently conducted zero interest rate policy and a strong correlation between 10-year bond yields and the relative performance of growth versus value.
Also in value stocks’ favor are cyclical considerations. In the end, weak, longer periods of growth outperformance was historically followed by five to seven strong value years in the past. When that happened, a portfolio of value (long) and growth (short) grew in the following years between 24 percent and 87 percent, according to calculations of the German asset manager StarCapital. If history is repeating itself, value stocks should soon move on the fast track.
Of course, repetition of the past is not guaranteed. One disadvantage at the expense of value stocks may be that nowadays, numerous investment products follow this value approach. As data from S&P Dow Jones Indices show, the growth in assets of U.S. ETFs that follow a value approach, has outpaced the investment growth of the S&P 500 Value Index by nearly tenfold between 2007 and October 2015. “With so much energy directed to exploiting the excess returns available through value investing, maybe the only ‘value’ stocks left are the value traps, those stocks whose prices are low as their prospects are determinedly poor,” says Tim Edwards, senior director at S&P Dow Jones Indices.
“In such circumstances, there is little hope for a reversal in the market cycle’s providing the much-needed fillip to value investors – investors might be better served focusing on other factors.”
Combined approach is most successful
In fact, it seems to make sense not to strictly distinguish between value and growth in the search for investments. Thus, an attractive valuation on first sight, in the case of many value stocks, often has to do with internal problems or a bad industry environment, which justifies a lower valuation. Also, it can sometimes take forever for so-called value-traps until the market starts to classify really cheap stocks as undervalued also, and closes the valuation gap. Growth stocks, however, can stay overvalued for a long time, but once the bubble bursts, their stock prices can go down rapidly.
Against this background, the best advice is likely to not differentiate too much between value and growth, but more between “good” and “bad” stocks. That may sound primitive, but it can lead to amazing results.
To get there, it is vital to bear two central aspects in mind: First, medium- to long-term rising prices are more likely at an entry at reasonable prices. But remember: Not only traditional value stocks carry a low valuation, but high-growth stocks do as well, provided that their price-earnings-to-growth-ratio is attractive. Second, to be able to make money with such stocks as quickly as possible, give preference to stocks that are already moving upward.
This approach is covered by a research paper of StarCapital. According to the results, strong momentum value stocks since 1986 delivered on average almost 9 percent higher capital gains before transaction costs than the benchmark, and thus performed the best.
Put in praxis, this would mean to still avoid investing in IBM, despite the fact that the stock looks cheap. This was also the case in the last few years, but did not prevent a downtrend in the stock price. IBM will only become interesting as an investment when the numbers show that the currently shrinking IT-service company is back on a growth track, and when this is accompanied by encouraging chart-signals. In contrast to that, a good buy is Travelers Companies, another Dow Jones member, since the U.S. insurer can convince with a moderate valuation (PE 2016e: 11.7) and price momentum (new record highs) at the same time.
Conclusion: The outlined approach should be taken into account when value, growth and momentum supporters once again sell their approach as the only right one, especially since more flexibility in thinking off the beaten track will probably be rewarded by better investment results. And that, in turn, helps to become the real winner most stock market participants want to be.