AUGUST 9, 2015
GROWTH INVESTING VS. VALUE INVESTING
Show people the following chart and one hundred percent will choose to invest in the equities represented by the blue line:
Which position would you invest in? Chart courtesy of the Irrelevant Investor.
The reason is obvious; over the long term shown here (1979 – present), the equities represented by the blue line (value) produced almost triple the return of those represented by the red line (growth).
The blue line represents the Russell 2000 (small-cap) Value Index, and the red line is the Russell 2000 (small-cap) Growth Index. It is well-known by most investors that small-capitalization value stocks are one of the best ways to invest their money over the long term. There is a very well-developed body of scholarly work backing up this statement, and the chart above proves the point.
However, this chart representation dramatically simplifies the decisions that investors must make on an ongoing basis. The chart does not take into account those times when Growth significantly outperforms Value.
For example, during the period from August 1998 to February 2000, the Growth Index returned 83% while the “no-brainer” Value stocks lost 1%. How many people could maintain discipline and stick with Value in this type of situation? If you were an investor in the late 1990s, you know how popular technology and internet stocks were at that time. Dubbed the 'new economy,' investors believed that everything had changed and the only profits were in growth companies with a '.com' on the end of their name. We all know what happened at the end of that investment period.
To remain a dedicated value investor through the late 90s was like having your teeth pulled out with a pair of pliers. You watched everyone around you making money while you struggled along at breakeven (if that). Those periods of underperformance are extremely challenging and test a value investor's resolve.
VALUE STOCKS UNDERPERFORMING NOW
The market is currently in a similar period of value stocks underperforming growth stocks. The first half of 2015 has been the fourth weakest period for small-cap Value relative to small-cap Growth since the inception of the index in 1979. As you can see from the chart below, in 2015 value has underperformed growth by -6.14%.
2015 has been a difficult year for value stocks, as they underperformed growth stocks by 6.14%. Chart courtesy of the Irrelevant Investor.
The chart below shows the Russell 2000 Value ETF (IWN in black) and the Russell 2000 Growth ETF (IWO in blue) since the market bottom in March 2009. As you can see, the two charts stayed closely intertwined until the middle of 2013 when Growth began to pull away. By May 2014, Growth had taken a significant downturn and was back in line with Value. However, since March 2014, Growth stocks have significantly outperformed Value stocks:
Taking a closer look since November 2014, We can see that Growth stocks (blue) have produced a return of about 12% while Value stocks (black) are slightly negative. It is for this reason that our portfolios have underperformed the market, and why we have been mostly in cash for the last month or so.
ADJUSTING OUR STRATEGY
One of the great things about being a value investor is that you are not stuck in a singular rut. At times when the market has reached an extremely low nadir after a selloff, such as March 2009, we can use the Benjamin Graham approach. That means buying the stock of potential liquidation situations with current assets (especially cash) selling for 30¢ or less on the dollar. That is exactly what we did in 2009, with the result being a 1600% return that year for our small-capitalization DEEP VALUE Portfolio.
On the other hand, our RELATIVE VALUE Portfolio has produced excellent performance by seeking quality, mid and large-capitalization companies that are selling at a discount to their peers.
There are many roads to identifying value in the US stock market. One way would be to identify the most undervalued of the 'growth' group of companies. Another proven approach is to use the GARP (growth at a reasonable price) method.
GARP is a strategy combining value and growth attributes when selecting individual stocks. One of the well-known proponents of the approach is Peter Lynch, the now retired long-time portfolio manager of the Fidelity Magellan fund. When he stepped down from everyday investing in 1990, he'd used the strategy to achieve annualized returns of 29% over a 13-year period.
The fundamental ratio usually used for GARP stocks is called 'PEG.' This formula takes a company's trailing 12 months P/E ratio and divides it by the company's expected earnings growth rate. For example, a stock with a PE of 12 and a forecasted growth rate of 15% per year would have a PEG ratio of 0.8. Theoretically, companies should have a PEG ratio of about 1.0. That means the company's growth justifies its earnings multiple. PEG's of less than 1.0 can signify undervaluation.
Our preference is to avoid anything to do with the earnings because the accounting department easily manipulates them. Growth is also a gray area that is based on analysts estimates. One of the approaches that we use is to change the formula into what we call PSG.' By this I mean Price/Sales divided by estimated sales growth. The Price-to-Sales ratio is a proven winner in stock picking that cannot be manipulated, and we have used it in almost every one of our stock-selection systems since IV's launch in 2004. We can also look at a company's sales growth forecasts rather than its earnings growth to use in the divisor.
In the coming weeks, we will be working on stock-selection systems that take growth into consideration. If we can find a robust winner, we may be able to add stocks to our portfolios even though fundamental value stocks continue to struggle.
We hope that we have thoroughly discussed the issues in this Value Alert, and you can implement these ideas to your benefit. Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach. If you have any questions or comments, please contact us with a support ticket.
Best Wishes for Another Week of Intelligent Value Investing,
Not an IntelligentValue Member?
Limited time only.
Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. If you are not sure if value investing or a particular investment is right for you, we urge you to consult with a Certified Financial Advisor. Neither IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.