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Growth vs Value Investing Explained

By June 27, 2024July 3rd, 2024featured articles, Uncategorized
Growth vs Value Investing

We often talk about ‘Growth Investing’ and ‘Value Investing’ on this website and how growth stock investing has been in vogue for an unusually long period (since mid-2006). So, this week, in an educational-style piece, we thought that we would use a simple framework to explain the essential difference between the two terms and why, at this point in time, it has particular relevance.

The table below highlights Company A with an initial earnings yield valuation of 3.5% (a price-to-earnings ratio of 28.3[1]) and whose earnings are expected to grow at an annual rate of 11.4% for the next 9 years. On the assumption that the share price remains unchanged, at that rate of growth Company A’s earnings yield will reach 9.4% by end of year 10.

In contrast, Company B starts off on a higher earnings yield of 5.5% (a price-to-earnings ratio 18.2) and whose earnings are expected to grow at a lower annual rate of 6.1% for the next 9 years. Again, on the assumption that the share price remains unchanged, at this lower rate of growth Company B’s earnings yield, too, will reach 9.4% by end of year 10.

So, the faster growing company (A) and slower growing company (B) are expected to offer the same earnings yield by year 10. If after year 10, both companies are then expected to grow their earnings at the same annual rate, an investor should be agnostic regarding which company to invest in today.

We have simplified the example to make our point, but that is essentially the difference between growth stock investing and value investing.

An investor more attracted to the company offering better value today (Company B) might do so on the basis that a ‘bird in the hand is worth two in the bush‘. In other words, the value investor will take the higher earnings yield today because tomorrow (future growth) is uncertain.

If, however, an investor expects Company A to grow faster than the outlined 11.4% annual rate, she might choose to invest in Company A.

For Company A, we can substitute the S&P 500 Index as of today. It trades on a price-to-earnings ratio of 28.3 (an earnings yield of 3.54%). In contrast, Company B represents the average valuation of the S&P 500 Index since 1950 – a price-to-earnings ratio of 18.2, or an earnings yield of 5.5%.

And the long-term rate of annual earnings growth for the S&P 500 Index since 1950 has been 6.1% (the same as we have assumed in the table for Company B). To justify today’s valuation of the S&P 500 Index relative to history (28.3 times earnings versus a long-term average of 18.2 times) one has to assume that the S&P 500 Index will achieve annual earnings growth of 11.4% for the next ten years, almost double the long-term average.

This unusually high level of valuation of the key US equity market today is why we have been introducing coverage of several funds that have a more value-oriented focus to the website and they include:

  • iShares MSCI World Value Factor ETF
  • Schroders Global Recovery Fund
  • AVI Global Trust
  • AVI Japan Opportunities Trust
  • Fidelity Special Values
  • Murray International Trust
  • M&G European Value Fund
  • Smead US Value Fund

Of course, stocks that we cover on this website (www.gillenmarkets.com) that offer decent starting value, above-average track records of growth in the past and with business models that should underpin reasonable growth in the future can also be considered core holdings, and a selection from the website might include:

  • Berkshire Hathaway
  • Markel
  • Fairfax Financial Holdings
  • DCC plc

If the key US equity markets do encounter a sell-off on valuation grounds, all funds/stocks will likely decline in price, temporarily at least. Those funds/stocks offering better value along with sound growth prospects will probably recover faster in any ensuing recovery and should offer well above bank deposit-type returns on a 5-10 year view.

To finish off, the chart below highlights the struggles of ‘Value Investing’ since mid-2006. Growth stock investing has had an unusually long-run as judged over the 50-year period from 1975 to 2024 inclusive. The recent period of outperformance of Growth Stock Investing ended in mid-2021 but, as of yet, there has been no swing back in favour of Value Investing.

The boost to Growth Stock Investing from the emergence of artificial intelligence and the potential for AI to boost earnings growth for an extended period is probably the reason. At present, it is the expectation that AI will boost growth that is leading to such high valuations for growth (tech) stocks today. Only time will tell whether the reality matches up to the expectations!

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Rory Gillen
Founder, GillenMarkets

27th June 2024

[1] Based on the reported GAAP earnings for the last 12 months including the quarter to June 2024. Earnings data sourced from S&P Global.