Any young investor browsing the financial pages will have come across the term’s ‘growth’ and ‘value’. They describe very different investment approaches. But what do they mean, and should it matter to you?
This is an investment strategy that aims to identify stocks where profits are growing quickly and are expected to continue to grow in the future.
Growth investors believe that the most important factor driving stock returns is the underlying growth of that company’s profits.
Microsoft is a good example. From 2019 to 2020, Microsoft grew its profits by 20% per year*. Looking forward, market experts believe this growth will continue, with consensus expectations forecasting 27% growth in 2021**. The strength and consistency of its growth has delivered great returns for investors.
Growing profits also compound over time: they can be reinvested in the business and help to drive further success. Consider how Microsoft profits from its core Office products and how this helped to fund the development of its cloud computing division, Azure, or Microsoft Teams. Growing profits are a virtuous cycle when used to fund further development for a business.
This is an investment strategy that aims to identify stocks trading below their estimated ‘fair value’ and then profit as the share price adjusts. Once the shares achieve their target valuation, investors will typically then rotate into new bargains.
Value investors undertake a vast amount of primary research, look at company accounts, and meet company management all with the purpose of deriving their own ‘fair value’ for the company.
While any stock can be a value company, a good example at the moment would be the banking sector: an estimate of fair value can be made by looking at the bank’s net assets (assets minus liabilities), using readily available public information.
For example, currently NatWest Group is trading at roughly half of its net asset value and might therefore be considered “cheap” and worthy of investment for a value investor. In general, value investors will be looking at those parts of the market that are unfashionable and out of favour.
Which is best?
Growth investing works well if the company continues to meet or exceed its growth targets. However, if a company is forecast to grow at 15% and it only delivers 10%, though still a positive absolute number, this can be bad news for the stock price!
Value investing works well if other investors start to spot the same bargain that you have and begin buying shares, driving the price up. However, value investing often requires patience and the emergence of a catalyst – something that will generate interest in the stock and bring new investors to the stock.
The truth is neither style is inherently better, both have their proponents with many illustrious investors on both sides of the debate. Crucially though, one style is often more prevalent in markets and that can make a difference to returns.
Why does this matter to me?
If you’re new to investing, understanding these terms is crucial. Each style has their advocates and has had strong and weak periods of performance.
The last decade or so has been a paradise for growth investors. This is shown as the MSCI Growth Index has returned 239% from 10 year to the end of January 2021, while the MSCI Value Index has returned 99% in the same period***.
This performance divergence has been driven by the prevalence of very low interest rates and ultra-accommodative monetary policy. As the financial system emerged from under the cloud of the global financial crash in 2008/09, central banks across the globe unveiled new policy tools, such as quantitative easing, to stimulate the economy and meet their target inflation rates. Rates remains low today and low rates are generally thought to favour growth investing as future profit growth is discounted at a lower rate, so future profits are worth more.
However, while it has been the right call to invest in growth for the last decade, at some point the rules of the game might change. One of the biggest threats to growth stocks is the emergence of inflation. This might lead interest rates higher, which will favour value stocks, such as energy and mining companies. Indeed, higher inflation is forecast for 2021 by many economists and strategists as the global economy rebounds from the pandemic.
We believe changing market conditions favour active managers, who can switch between styles dependent on conditions in financial markets. Young investors need to understand the style of equity investments they hold, so that they can fully understand the performance of their portfolio.
* Thomson Reuters, 12/02/21
** Thomson Reuters, 12/02/21
*** Thomson Reuters, 12/02/21
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