Lesson 2-Growth and Value Funds

Differences between growth and value funds:

Growth Funds typically include companies that exhibit above-average earnings and market growth potential, even during economic downturns, while value funds include companies that are considered undervalued, trading below what they are worth. Understanding the life cycle of a company is key to understanding growth investing. Initially, businesses grow at a substantial pace, generating high returns in revenue and profit and reinvesting profits to expand business operations instead of paying out dividends. Growth stocks retain their status until the company has fully expanded and reached its potential. Upon full maturity of the business, investment opportunities for growth diminish, resulting in growth stocks transitioning to value stocks and distributing profits in the form of dividends.

Value stocks can be thought of as stocks undervalued relative to their earnings and growth potential, therefore selling at a bargain, the assumption is that the market will recognize the stock is trading below its intrinsic value, resulting in the stock price rising. Value funds include companies that have fallen out of favor but still have strong fundamentals which the market is underestimating, presenting an ideal entry point/buying opportunity as the stock price may rise when investors recognize it is trading below its book value. To identify these companies, value investors use fundamental indicators to identify stocks trading at a discount to the P/E, P/S, P/B, and operating cash flow ratios. Value investors also create financial models projecting future earnings, profits, and cash-flows based on the company’s business model and industry trends to seek long-term quality companies trading below their intrinsic value. The most famous value investor, Warren Buffet, only buys stocks of high-quality businesses trading below their fair value that he would hold indefinitely.

News adversely affecting the stock price, including lower than expected earnings, supply chain inefficiencies, and issues relating to company products can create doubts about the company’s long-term prospects, pushing the stock price to levels below its true value, presenting buying opportunities for value investors. However, value investors can incorrectly forecast stock price appreciation, as stocks that appear undervalued may be correctly priced. Also, a lack of profits can result in a company's quarterly dividend payments being cut.

Value companies make up most of the financial, industrial, energy, and consumer staple sectors, the most notable large-cap value stocks today include, Berkshire Hathaway, J.P.Morgan, Bank of America, Exxon Mobil, and Johnson & Johnson. Value stocks are priced low relative to their sales and profits and carry less risk than the broader market, they include larger established companies operating proven profit-making business models generating revenue above costs and have lower sales and earnings growth potential. A large proportion of returns are distributed in the form of dividends to shareholders. Value funds are suited for risk-averse investors approaching retirement and seeking portfolio stability, regular dividend payments, and moderate yet sustained capital appreciation.

Growth stocks are predominantly technology, healthcare, and consumer discretionary stocks and are expected to grow at a faster rate than the broader market/have the potential to outperform the overall market. As a result, investors pay high P/E and P/S multiples based on the expectation of high future profits and sales, therefore, the current stock price is valued high relative to current sales and profits. Expectations of increases in future revenue and profit are priced into growth stocks, making them expensive now. Consequently, if the company’s future earnings growth does not meet expectations, the stock price will fall sharply, making them more volatile and risky than value stocks. Growth investors can incorrectly forecast a stock's EPS (earnings per share) growth, leading to a sharp fall in the stock price.

Growth funds are more aggressive taking on greater risk with the potential for higher return, the most notable established large-cap growth stocks today include Microsoft, Apple, Amazon, Tesla, NVIDIA, Home Depot, Facebook, Netflix, and Google. They pay little to no dividends, reinvesting retained earnings into R&D, advertising, and M&As to expand their services/products with the aim of increasing revenue at a faster rate than their value counterparts. Growth stocks transition from businesses building product operations to leaders in their respective industries, resulting in stock price appreciation. These stocks experience price swings of greater magnitude, as a result, they are best suited for risk-neutral investors, not reliant on dividend payments, seeking aggressive capital appreciation realized over the long run.

In the short run, the performance of growth against value largely depends on which point in the market cycle the economy is in. Growth stocks perform better in low-interest rate and low inflation environments, a sustained bull market with company earnings rising or during periods of average economic growth. Value stocks are often stocks of cyclical industries (i.e. energy and financials) and perform better in periods of economic recovery and high economic growth or high inflation and interest rate environments.

Which investing style yields the highest returns:

Historically, value investing has outperformed growth, returning 1,344,600% since 1929 compared to 626,600% for growth over the same period. The 1st and 2nd industrial revolutions favored value companies by boosting industrial production via the spinning jenny and rise of the modern factory, transforming the energy industry via the invention of electricity, and high-interest rate conditions increasing profits for banks. Trends shifted with the advent of the 3rd and 4th industrial revolutions, introducing general-purpose technologies favoring growth companies via the spread of automation and digitization in the use of electronics and computers, utilization and application of the internet, rise of supply chains and hyper globalization, AI and robotics, 3D printing and cloud computing. Since the 1960s, this has led to the emergence of tech MNC’s including trillion-dollar names like Apple, Amazon, Google, Facebook, and Microsoft who applied these general-purpose technologies in industry. As a result, growth has outperformed value over the last 60 years, demonstrated through $100 invested in growth funds in 1958, at the dawn of the tech revolution, yielding $9,380 by the end of 2004. The same $100 invested in value stocks would have grown to $7,046 in the same period. The global emergence of big tech names led to growth outperforming value by 448% over the past 25 years and by 228% over the past 15 years.

The tech revolution and growth's dominance over value is in its early innings. Illustrated through tech companies amongst the 5 largest cap companies in the S&P 500 growing from 2 in 2010, to 5 in 2021, representing 20.51% of the index by market cap. Each of the FAANG stocks, representative of growth stocks in America, reported record earnings in 2020 with an average gain of 36%, in contrast, broader market earnings declined 32% compared to 2019. Earnings are the key driver of stock prices, growth stocks record earnings are expected to continue while airline, banking, and energy stocks including Ford, Chevron, Bank of America, and American Airlines continue to experience sustained falls in earnings.

Recent trends support the case for growth stocks. Changes in the use of monetary and fiscal policy since the turn of the century, to stimulate economic growth, provide growth companies with cheap access to capital used to expand business operations. Increased online activity following Covid-19 has boosted demand for tech companies providing online services which encompasses a large part of the growth ecosystem. Investing in growth stocks is equivalent to betting that the technology sector will experience greater long-term growth than energy, financials, and industrials. Based on recent trends this seems assured, with growth stocks like Zoom, Salesforce, Square and Shopify all vying to become the next big industry names.

Risk-neutral young investors, not reliant on dividend payments, are well-positioned to benefit from a heavily weighted growth stock portfolio. This type of portfolio is recommended for investors with time horizons of at least 15-25 years, calculated 5-7 years from retirement. Contrary to day trading or market timing, high returns from growth investing are realized over the long term with high volatility along the way, justifying growth investing as a long-term play. Value fund portfolios, diversified with higher bond and precious metal holdings, are suited for investors within 5 years of retirement or in retirement. (Retirement portfolio - attached is a link to a portfolio for retirees. Please note, YoungInvestor recommends including VTV, Vanguard Value ETF, by reducing VTI’s portfolio weight from 30% to 15%).