Is the Tide about to Change? – Value Stocks vs. Growth Stocks

In Articles, August 2018, Investment Management, Tax Planning by Stephen Hanley

Written by Stephen L. Hanley, Investment Strategist
Evergreen Wealth Management

Only when the tide goes out do you discover who’s been swimming naked. – Warren Buffet

A classic stock investing debate has long existed between those investors favoring more growth-oriented companies and those favoring companies selling at a large discount to a fair price, also referred to as value companies. Choosing between these two ‘competing’ investing styles is like choosing between cake and ice cream. Most of us really want both.

In a perfect world, an investor can find solid growth companies selling at a discount to a fair company value, allowing you to receive a long-term return from both the company’s profit growth and its stock price; the best of both worlds! It would be akin to purchasing a beautiful home in California at a 50% discount to the neighborhood. Unfortunately, these deals are much more rare today than in 2009 after the real estate market’s collapse. In the stock market, we’ve seen an enormous and alarming disconnect develop over the past 18 months between traditional growth-oriented companies and those that are of the value-style category, as depicted below.

When looking at this chart, one should be reminded of one of investing’s core rules: never delude yourself into thinking you’re investing when you’re instead just speculating. Looking at today’s market, the current disconnect between growth and value companies’ stock prices makes us wonder if a good chunk of participants are starting to speculate rather than invest. As a result, we believe the need for proper long-term analysis and portfolio balance to offset potential speculation are becoming increasingly important. Avoiding emotional moves and speculation over the next two years will prove extremely valuable (and possibly difficult) for the long-term investor in order to continue meeting objectives. Many investors may need help over the coming years to avoid getting sucked into a trap similar to the tech stock bubble back in 2000 and financial stocks in 2008. Are we looking at an Amazon/Netflix bubble in 2020?

Stepping back, let’s define what makes a growth company a growth company, and what makes value, value? A little background may be helpful to demystify the growth/value jargon.

Value Companies:

Traditionally, accounts designed to provide a more stable, higher income, and reduced risk profile would be classified as a more value-oriented company. Value companies usually have mature business models that seek to maintain strong pricing power, modest growth, and typically reward long-term shareholders with a dividend payout or stock repurchases. The value category is often represented by larger companies such as Coca-Cola, Proctor and Gamble, Exxon Mobile, and Johnson & Johnson, to name just a few.

Growth Companies:

Growth companies are focused on higher revenue growth, expanding their market, and generally show lower profits due to higher investment in company expansion. They typically pay little to no dividends as they re-invest profits in expanding growth. Examples of growth companies are: Amazon, Google, Netflix, Nvidia, just to name a few.

At the right price, either value or growth can be very successful investments to own and can lead investors to long-term success. Both styles should be used in a well-diversified portfolio for balance and diversification. However, investor objectives may benefit from favoring one style over another and it’s important to be aware of the risk of overexposure to either.

Based on the study findings from Bank of America/Merrill Lynch over a 90-year period, growth stocks returned an average of 12.6% annually since 1926. However, value stocks generated an average return of 17% per year over the same timeframe. Bank of America/Merrill Lynch’s chief investment strategist Michael Hartnett added, “Value has outperformed Growth in roughly three out of every five years over this period.”

Historically we see (and expect) an ebb and flow of performance between growth and value stocks with value generally outpacing growth, long-term. However, we’ve found that extreme disconnects between these stock styles often serve as a precursor to a future problem. In the late 90s we saw the general market index pulled artificially higher by the technology sector and dot com craze. Clients abandoned well-diversified portfolios to chase the incredibly attractive, but unsustainable, tech returns. Many moderate and conservative investors no longer found themselves satisfied with balanced returns and desired the 50%+ returns of high growth tech stocks. This directly preceded the market collapse from 2000-2002. In similar fashion, many investors desired to switch from traditional growth investments to bank stocks after financial stocks ran up such large gains from 2003-2006. As we now know, many investors became overexposed to these financial stocks right before the 2008 collapse. In both cases, we saw an extreme disconnect between growth and value prior to the corrections. In these situations, investors were painfully reminded of the now-famous Warren Buffet quote: “Only when the tide goes out do you discover who’s been swimming naked”.

The common mistake made during times of market disconnect has been a general disregard for consistent, long-term focus that meets a planning objective, while rushing to the brightest, shiniest object.

Stay long-term objective focused

All of human unhappiness comes from one single thing: not knowing how to remain at rest in a room.
–Blaise Pascal

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. –Benjamin Graham

Investors often get into trouble when they stop accepting an ‘adequate’ and ‘safe’ return as acceptable. When objectives are being met – and yet the investor wants more – is when emotion seemingly pulls them toward speculative investments often akin to gambling. Even aggressive investors should take note to remain balanced with stocks and not become overexposed to a singular company, industry, or sector. Investing done properly should never expose an investor to long-term loss of principal over 10, 20, or 30 years.

Having a clear plan that is balanced and objectives-based is what will lead to accomplishing your goals. Measuring investing progress against improper benchmarks, becoming short-term focused, or wanting more than adequate or sustainable returns can lead to a dangerous mindset. Get caught up in the neighbors’-grass-is-greener mindset, and you may find yourself susceptible to a trap like 2000 or 2008.

Let me close with this tidbit from Warren Buffet, whom I consider my guiding light in investing:

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

Everything we do from planning to investment management is focused on keeping a sound intellectual framework from being corroded by emotion. We offer this emotion-free framework to help investors succeed over the long term. Our team holds a deep understanding, and over 50 combined years of experience, in watching investment and investor disconnects play-out. While we can’t avoid all the pain when the tide goes out, we can help foster resilience to avoid the pitfalls of an emotion-filled market.

https://www.investevergreen.com/single-post/Q2-2018-Market-Update