Note: Each week in this column, I’ll address a question discussed in recent client conversations. Who knows, it may just be on your mind as well

This week, the topic is Growth versus Value. Recently, a client asked for some clarification on what those two terms actually mean and if we have a preference in today’s equity markets

Beware of the Buzz Words

The financial media loves buzz words, almost as much as acronyms! Chief among them these days are Growth versus Value. While somewhat helpful, we believe there is far more to this discussion than two simple terms. Before we dive into the details, let’s back up and define a few terms

Key Definitions

Stocks – a share of stock represents ownership in a business. Buying a share of stock in a company (either directly or via a mutual fund or ETF) gives you a pro rata rights to the company’s future earnings and cash flows – either thru dividend payments and/or the change in the price per share after purchase

Earnings per share – Represents the income a business is able to generate from operations, less the costs of those operations, divided by the outstanding shares in the market

Growth rate – actual and estimated percentage change in key business metrics (such as earnings or revenues)

Price/Earnings (P/E) – a common valuation metric, which is calculated be dividing the price per share of a stock by its earnings per share. This number is also called the multiple and quantifies the “speculative” portion of the market. Said another way, it shows how many years of earnings investors are willing to pay for in today’s price

Discount rate – the prevailing interest rate in the market, for instance the 10-year US treasury rate

What’s the difference between Growth and Value?

Growth and value are two fundamental approaches, or styles, of investing.   They are often viewed as the direct opposites of one another and can remind you of the age old tale of the tortoise (value) versus the hare (growth). Financial media and investment products (like ETFs and mutual funds) use these styles to segment stocks. Let’s discuss each of these styles (as the markets and indexes define them) below

Growth vs. Value – Style Buckets

Growth indexes include companies that are focused on, you guessed it – growth. They have high projected earnings and/or revenue growth. As growth is the priority, these companies reinvest earnings in themselves in order to expand and may or may not be presently profitable or generate positive free cash flow. They have higher P/E ratios (or sometimes negative if they are losing money) as investors pay up for that potential future growth

All of the major indexes have a “Growth” index (ie: S&P 500 Growth Index, Russell 1000 Index, etc) and each has their own criteria for inclusion. But typically, it’s a high level of earnings and sales growth and high valuation metrics (such as P/E ratios or others such as Price/Sales or Price/ Book) as compared to other companies in the index

As Growth style is focused on high earnings growth companies, it tends to be comprised largely of technology, communication services, and consumer discretionary sectors

On the other side are Value indexes. Value tends to define companies with low P/E ratios, slower or declining growth rates, and businesses that tend to be in a more mature stage. Value stocks also tend to have higher dividend rates as cash generated isn’t used for growth initiatives and is instead returned to share holders. Value stocks tend to focus in energy, financial services, and utilities.

Interaction with Interest Rates

The Growth versus Value debate has intensified in recent months. For decades, growth indexes have outperformed value indexes. However, in late 2021 and into 2022, that dynamic has reversed. Why? Two words – interest rates. A stock’s value should be the sum of its future cash flows (numerator), divided by the implied interest rate (denominator). For a growth stock, it has a rather high numerator, given the earnings estimates that extend out for years/decades thanks to a high growth rate. And with interest rates near zero, the denominator was very low. High number divided by low number = higher number. Once interest rates started to rise, the denominator rose and valuations declined. This is a very simplified illustration but serves to illustrate the key points – Growth sector tends to be impacted more by a change in interest rates than value

Our approach to Growth vs Value

When asked if we prefer Growth or value, our answer is: Yes.

This is because there are factors (or characteristics) commonly attributed to stocks in Value indexes – as well as factors commonly attributed to Growth indexes – that we find advantageous in today’s market. Almost all of our current holdings show sings of both

Here is a list of some of the factors we are focused on in today’s markets, as well as notation of which index/style they are typically tied too:

• Upward earnings revisions (growth)
• Earnings and revenue growth (growth)
• Secular growers/market dominance (growth)
• High productivity and innovation (growth)
• Strong free cash flow (value)
• Balance sheet quality (ie: low leverage) (value)
• Below market multiples (value)
• Short duration earnings (Price/free cash flow) (value)

Know what you own

As has always been our approach to investing, you need to know what you own and understand why you own it. It isn’t as simple as investing in a style or an index. It’s a company-by-company evaluation, in context of the broader economic picture). You never know – both tortoises and hares could very well win the race!

Invest on,
Pam

Note: All commentary above is as of the date of this post and is for education and informational purposes only. Windermere and its principals do not intend for this to serve as investment advice and are not responsible for any actions taken based on this article. Consult your financial advisor before taking any actions as it relates to your own investment portfolio.