Growth vs Value Investing Styles

Rotation: the decade-long stretches where one style wins

Neither style leads permanently, and the periods of leadership are long enough to break most people’s patience. Value dominated for long stretches of the 1970s and the 2000s; growth dominated for much of the 1990s and the 2010s. Each run lasted long enough for commentary to declare the other approach obsolete, shortly before it stopped working.

The mechanism behind much of this is the interest rate. Growth companies have most of their value in cash flows a long way out, which a higher discount rate compounds against hardest. Value companies have more of their value in near-term earnings and dividends, which are less affected. So a falling rate environment tends to favour growth and a rising one tends to favour value, which is a description of a tendency rather than a rule you can trade mechanically.

The definitions are also less precise than they sound. Index providers classify stocks into growth and value using a handful of ratios, most commonly price to book, price to earnings and forecast growth, and a company can move between the two classifications on a rebalance without anything changing at the business. So a fund labelled value holds whatever passed a screen on a particular date, which is a weaker statement than the label implies.

The value trap and the growth de-rating

Each style has a characteristic way of failing, and both look like the opposite of a mistake while they are happening.

• The value trap. A stock is cheap on every metric and stays cheap, because the business is in structural decline rather than temporarily out of favour. The multiple never re-rates; earnings fall to meet it. Newspapers, physical retail and legacy hardware supplied a decade of these.
• The growth de-rating. The company delivers, but the market decides that growth is worth less than it was. The stock falls 40% while revenue rises, which is disorienting because the thesis appeared to be working.

The defence in both cases is the same discipline: state in advance what would tell you the thesis is wrong, and distinguish that from the price simply moving against you. The risk management guide covers how to hold that line when a position is underwater.

Knowing which bet you already own

Most portfolios are tilted without the owner deciding to tilt them. A capitalisation-weighted index fund is weighted toward whatever has risen most, which after a long growth cycle means a substantial growth position. A portfolio assembled from high-yield stocks is a value position with a sector concentration in financials, utilities and energy attached.

The useful exercise is to calculate the weighted average P/E and dividend yield of what you hold, then compare both to a broad index. The answer tells you which side of the rotation you are on, and therefore which environment will be uncomfortable. Blending deliberately is a legitimate answer, and so is choosing a side, but doing either by accident is not. Run the long-run arithmetic on both paths through the compounding calculator, and check the terms in the glossary if the multiples are unfamiliar.