It has been a slog for value investors these past years. Growth stocks have handily outperformed value stocks since December of 2006.
That tried and true investment tenet “regression to the mean” has so far fallen flat when it comes to cheap stocks. Despite a growing chorus of value stock cheerleaders, the group has continued to underperform in 2020. This hasn’t stopped many from speculating about when the tide will turn, with recent stories suggesting that value has generated excess return during the month of May. Seriously? Three weeks of outperformance does not a trend make.
But what exactly make a stock a value or growth stock? The definitions are fraught. Is Apple, for example, a value stock or a growth stock? I would argue that over the last ten years, it has been both at one point or another. The same could be said about Microsoft over the last 20 years.
Perhaps it is much more important to worry less about categories and more about buying great companies. Warren Buffett had it right when he said, “It is far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”
So what actions, if any, should you take when it comes to balancing growth versus value stocks in your portfolio?
Don’t overdo it
First and foremost don’t split the difference. When unsure, investors tend to overdiversify. If one home improvement stock is good, two will be better. Not necessarily.
Equally weighting value and growth is akin to buying the S&P 500. Save your time and buy an index fund. Author and economist Peter L. Bernstein once wrote: “Diversification is the only rational deployment of our ignorance.”
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Which beg the questions: What exactly is the optimal level of diversification required to dilute our ignorance, but not our performance? And how to anticipate the relative outperformance of value versus growth stocks?
It all depends on your view of the economy. If you believe that the U.S. will face a protracted recovery – think U or square root shaped you may want to consider overweighting growth stocks in your portfolio. A V-shaped recovery would argue for value stocks. Why?
• When economic growth, and consequently, earnings growth becomes scarce, investors are generally willing to “pay up” for growth characteristics. If a company is trading at a multiple of 25x to 30x earnings, but is growing earnings at 20%-30% some would consider that a fair trade. Much more attractive than, say, a company trading at 6x earnings with no growth. Cheap is not better than excellent.
• When economic and earnings growth is robust and, therefore, plentiful, valuation becomes more attractive to investors and value stocks should shine. The 1980s were a perfect example of strong economic growth and strong returns for value investors. The last recent bright spot for value investors was short-lived but took place in 2017 when investors were bombarded with references to strong global synchronized growth almost every day. When that bubble burst, investors piled back into growth stocks.
Value and growth go hand in hand
Using those two basic premises as your guide, remember that value and growth are actually inherently linked. Value investing, as defined by the great Benjamin Graham, focuses on buying a company for a price below the underlying intrinsic value of the business. But growth in earnings is an important component of the calculation to determine the intrinsic value of the business. The two go hand in hand. Value and growth.
And, that may, in fact be the answer. It is likely just as simple as buying outstanding companies that will weather the storms that inevitably come. Companies who are gaining share during this current crisis, acquiring their competitors or raising their dividends. The actions of great management teams provide the strongest indicator of a company’s future growth potential which, in the end, is the reason we own stocks – whether we call them growth stocks or value stocks.
Nancy Tengler is chief investment officer at Laffer Tengler Investments and the author of “The Women’s Guide to Successful Investing.”
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