Growth vs. Value Investing

"Overweight cheap asset classes and underweight expensive ones." This strategy sounds simple, but it’s not. There are two big challenges: 1. It isn’t easy to catch turning points. “To unlock a valuation advantage, you need a catalyst,” said my colleague Charles Shriver, portfolio manager and cochair of the Asset Allocation Committee. That’s why our process incorporates fundamental, macroeconomic, and sentiment factors. 2. Secular changes can create "value traps”. For the last 20 years, relative to growth stocks, value stocks have gotten cheaper and cheaper... and cheaper. For investors who seek to make money from relative valuations reverting to the mean—which historically has tended to work over time and across asset class pairs (see references below)—that’s about as disheartening a chart as I’ve ever seen. What has created this mother of all value traps? In one word, technology. In more words, corporate business models have shifted from investing in hard assets (property, plant, and equipment) to intangibles (Research & Development). The breakthroughs from intangible investments have been highly disruptive to legacy business models. “You need to incorporate innovation into classic macroeconomic theory. If the pace of innovation is increasing, it’s easier to be in growth stocks,” said a member of our Asset Allocation Committee. Accounting practices have failed to keep pace with this shift. According to Lev and Srivastava (2002), growth companies—especially tech companies—that invest in intangibles have looked increasingly expensive due to decreases in three important metrics: ○ Book values: “A firm investing heavily in R&D, IT, brands, or business processes (e.g., customer recommendation algorithms), may appear to be an overvalued company... whereas in reality its valuation isn’t excessively high when book value is properly measured.” ○ Earnings: “Reported earnings of companies with increasing investments in intangibles are understated, due to the immediate expensing of intangibles, leading to overstated P/E ratios.” ○ Cash flows: “Cash flows [are also] calculated after the deduction of intangibles, and therefore, do not solve the accounting-deficiency discussed above.” For more on this discussion: https://lnkd.in/eimDS9_P 1. See back test results in Page, Sébastien (2020), “Beyond Diversification: What Every Investor Needs to Know About Asset Allocation”, McGraw-Hill; p 45-60. Asness et al. (2013), “Value and Momentum Everywhere,” Journal of Finance, Vol. 68, Issue 3; Bhansali et al. (2015), “Carry and Trend in Lots of Places,” Journal of Portfolio Management, 41 (4). Summer 2015 2. Baruch Lev and Anup Srivastava (2022), "Explaining the Recent Failure of Value Investing", Critical Finance Review: Vol. 11: No. 2, pp 333-360.

David Einhorn said, "The opposite of value is not growth, but anti-value." Undervaluation comes in many forms. It's not just about statistical cheapness – sometimes, growth stocks can be undervalued too. The key is to approach each opportunity with the same care as if you were buying the whole business. This philosophy has led me to construct a portfolio that doesn't fit neatly into traditional value quadrants. We own companies of various sizes, across the developed world, some even considered growth stocks. But make no mistake – each stock is selected based on the core principles of value investing. We demand a margin of safety for every purchase. The difference lies in recognizing that value can be found in unexpected places. A stock trading at 7 times earnings might look cheap, but it's not undervalued if those earnings are about to collapse. Conversely, a higher-multiple stock with sustainable growth might be a bargain. In this complex market, success lies in being flexible in where we look, but rigid in our valuation process. Read more of my investing thoughts here: https://lnkd.in/gpihxX9p

This got me thinking. Value investing has had a rough 20 years in the U.S. But the story is different outside the U.S. Here's what you need to know: → U.S. Performance: The Russell 1000 Value has returned 15.4% this year, while the Russell 1000 Growth has returned 24.1%. Over the past 20 years, value stocks in the U.S. have underperformed growth stocks by an average of 0.9%. → Historical Context: We are in the longest period on record where value has underperformed growth. However, there have been times when other premiums also experienced long periods of underperformance. For example, U.S. stocks have underperformed U.S. Treasury bills in three separate periods longer than 12 years. Despite this, U.S. stocks have outperformed Treasury bills by 8.7% on average from 1927 to 2023. → International Performance: In developed markets outside the U.S., the value premium has averaged 2.7% over the last 20 years. In emerging markets, it has averaged 7.5%. Any theory suggesting that value investing is "broken" must explain why it has performed well outside the U.S. → Valuation Changes: One major factor for the outperformance of growth stocks in the U.S. has been changes in valuations. Growth stocks have become more expensive based on various metrics like book value, earnings, cash flow, or sales. This has boosted their performance. Valuations are the best predictor we have of future returns. Currently, value stocks are very inexpensive compared to historical averages, suggesting their future returns may be above average. → Future Outlook: It is possible that growth stocks will continue to get more expensive or outperform expectations. However, making investment decisions based on past performance, especially when value stocks are extremely cheap compared to growth stocks, is not advisable. Stay informed and make wise investment choices.

Growth vs. value is the most pointless debate in investing. It's a false choice. Investors talk about growth and value investing like tribes you have to defend forever. Neither camp is as important as people make them out to be. Many value investors gravitate toward slower-growing businesses because they're easier to understand and forecast. It works, but it can cause investors to ignore great businesses simply because the future is harder to model. Growth investors often make the opposite mistake. They're willing to underwrite ambitious outcomes and large market opportunities. But in some cases, they become so focused on growth that valuation becomes an afterthought. Both camps are going about it wrong. Fast growth doesn't automatically make a business expensive. Slow growth doesn't automatically make a business cheap. The exercise is the same either way. Estimate what the business is worth and compare that value to the price you're being asked to pay. For me, every company is just a valuation exercise. Sometimes the opportunity is in a slow-growing business. Sometimes it's in a company growing 30% or 40% a year. I don't particularly care where the value comes from. I'm interested in situations where the market's expectations are disconnected from reality so I can make the most of it. The labels are useful for categorization. They're much less useful for finding opportunities. ➕ Follow Chris Murphy, CFA for more on valuation, business quality, and long-term investing. ♻️ Repost if you think investors spend too much time defending labels and not enough time valuing businesses. 📩 Subscribe to my Substack for deeper dives on institutional investing, capital allocation, and investment process: longrace.com