Chris Watling

The debate over whether a value or a growth style produces better long term investment returns continues, with staunch advocates on both sides. Certain high profile investors such as Warren Buffett continue to champion the Benjamin Graham school of value investing while, in contrast, recent BAML fund managers’ surveys have shown the higher P/E ratio FANG stocks to be one of the most favoured trades.

Below we analyse what could be driving performance divergence. In particular, was Jeremy Grantham right when he said that the value style has a hard time ahead? Or is growth’s recent outperformance about to fade?

Throughout most of the 20th century, value stocks outperformed growth stocks. The total return on a buy-and-hold investment in 1927 in large cap value stocks would be superior to an investment in large cap growth. Taking the whole period together, though, is somewhat misleading, as value returns have not always dominated. Between 1927 and 1940, and from the early 1980s up to the present day (except for during the last economic cycle) growth shares tended to outperform value.

Fig 1: Relative performance of large cap US growth vs. value* stocks shown against US 10 year bond yields


*NB our data merges indices from Ibbotson & Associates and MSCI 

Interestingly, during both periods of secular outperformance by growth stocks, the economic environment was one of falling long term interest rates (fig 1). That is, there were secular bull markets in bonds (and interest rates) up to the early 1940s and since the early 1980s. The Russian economist, Kondratieff, identified long cycles in interest rates, postulating that a full cycle – i.e. a rise and a fall in interest rates – typically lasts 56-60 years.

This rate cycle has been ongoing now for 69 years. Unless, as we outlined, it ended in July 2016.

Whilst clearly this number of data points/turning points is insufficient to draw any robust conclusions (statistically), theoretically it makes sense that growth outperforms in a period of falling interest rates. Growth stocks tend to be valued using long term discount factors. Falling bond yields should therefore support an upward re-rating of the valuations of growth stocks. Conversely rising bond yields should undermine those valuations. Equally rising bond yields are also often/typically accompanied by rising inflation. Value stocks are usually dividend plays with those value companies often themselves endogenous in the inflation process (e.g. utility companies, food producers, staples) and, as such, able to protect earnings growth and dividends in a rising bond yield environment (and therefore outperform).  

Fig 2: Relative performance of large cap US growth stocks vs. large cap US value stocks shown with the relative performance of S&P500 technology vs. the index.

Also of note in this debate is the dominance of the technology sector in recent years (i.e. in driving growth). Since the late 1980s, when our sector data began, the relative performance of growth vs. value has largely tracked the relative performance of the S&P500 technology sector vs. the broader S&P500 index (fig 2). In that period of time the weight of the technology sector within the broader market has grown from ~7% to ~25%.  

As such, going forward the relative performance of value and growth is likely to continue to be dominated (in the near term) by the performance of US technology as well as by the medium term outlook for the US 10 year bond yield. As it stands, we view bonds as attractive at current levels (i.e. yields should fall in the near term). In the longer term (perhaps after the next cyclical bear market and at the start of the next bull), we would anticipate renewed weakening of bond prices (i.e. yields to move higher) and a continuation of the secular bond bear market which we anticipate likely began in the middle of 2016. 


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Nicholas Christian

Dear Chris. What exactly defines 'Growth' and separately 'Value' “The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle. It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one advisor to distinguish himself from another. But, to me, all intelligent investing is value investing.” — Charlie Munger. Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation, except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component - usually a plus, sometimes a minus - in the value equation. - Warren. E . Buffett.

Peter Brown

Great comment Nicholas Christian. They can be one and the same. I remember in 2008 when CBA dropped below $30 and Wesfarmers was around $15. Also COH and CSL dropped substantially in 2003, the former was about $18, the latter around $4. To my mind all were growing strongly and at the time selling at great prices. Stocks which have substantial growth still in them can be great value when they drop, in the short-term, substantially below their intrinsic value for emotional reasons that have nothing to do with their long-term prospects. They can also be great buys when the market has yet to grasp the idea that they have lots of growth in them and are selling at fair prices. The latter reason is precisely why I bought Altium, Xero, Appen and NextDC a few years back when they were still trading cheaply (and before their prices became fully valued).

Ronen S

@Nicholas, of course growth and value are interrelated, all investments are based on the expectation of getting higher returns. But when you look at companies like Google and Amazon whom never (ever) returned anything on their investment yet their share price is blazingly appreciating, to me that separates growth and value.

Nicholas Christian

@Ronen s Google (Alphabet) is profitable and had EPS (earnings per share) of 18..27 last year. Which accounts for a return on equity capital employed of about 10.5%. (source: MSN Money) Which was a big decline compared to the previous year. More than double that is expected this year. (maybe analysts getting a bit excited?) Amazon is profitable - However this may fit your category of 'growth' if that's what you wish to call it as such. There in 'growth' becomes 'speculation' . Value investing is about buying a company for a market price below the intrinsic value of the business. According to Buffett, this is the only way to truly invest, since paying a price above the estimated value -- usually hoping to sell it for an even higher price -- should be considered speculation. Self-image of a value investor: Buy low, sell high How a value investors sees a growth investor: Buys high, sells low Self-image of a growth investor: Buy high, sell higher How a growth investor sees a value investor: Buys low, sells lower Company's such as Air B n B, Uber and Tesla et al make zero profits. “Obvious prospects for physical growth in a business do not translate into obvious profits for investors.” Benjamin Graham (Warren's Lecturer and chief mentor) As a financial adviser 10 years ago we bought into a NASDAQ listed China based travel aggregator company call CTRIP(CTRP) Similar to Webjet. At the time it was trading on a PE of 50 times earnings. Yet we knew it had a huge (pardon the pun) runway ahead of it many times over the expensive price we paid. Since then its earnings and stock have risen over 1,100% and still trades on roughly 50 times earnings today. Was it 'growth' or was that a 'value'? I would argue they are too expensive today. Exactly Peter. Great business' at a fair price relative to their future prospects. These companies had 'temporary' issues not 'permanent'.

Chris Watling

Nicholas - Thank you for your feedback, we have some sympathy, but we are not entirely convinced by your comments (or more precisely Buffett/Munger’s comments). Theoretically, it is possible to distinguish ‘value’ and ‘growth’. Historically, stocks have been assigned as ‘value’ or ‘growth’ dependent upon their book-to-market ratio (i.e. the inverse of the price-to-book ratio) as outlined by the work of French & Fama in the 20th century. Other modern definitions include other fundamental factors such as recent EPS growth rates, dividend yields, and sales per share growth rates (full definitions are available on index providers’ websites). Whilst the terms ‘value’ and ‘growth’ may be misleading and some investors may not feel they are appropriate, they do refer to clear, well laid out fundamental screens that are widely used by equity fund managers. Indeed the chart we show in the blog shows that different ‘styles’ appear to perform well in different macro environments; specifically, as we illustrate, with those different environments dictated by the trend in the nominal risk free rate (i.e. US bond yields). Whilst we appreciate that one may take issue with the concepts’ labels, the relative performance resulting from their different fundamental characteristics is relevant to equity investing.