Growth vs Value investing – what’s the difference?

The legendary investor Warren Buffett was once asked what he would do if he were a young man starting his career again. Buffett said he’d repeat exactly what he did when he started out - read the financial reports of every company on the stock market and choose those that seemed most promising. His interviewer protested that there were over 27,000 companies listed in just the USA.

Buffett said he’d “start with the ‘A’s”.

If we had all the time in the world, we’d follow Warren’s advice and sit down to think carefully about each potential investment opportunity on offer. Fortunately, most of us have other claims on our time like jobs, friends and family.

We need an easier way of deciding which companies are worth taking a closer look at, and which might not be worth the effort.

Investing styles

Broadly speaking, stocks generate returns in one of two ways. Either the underlying business improves, or investors change their view of its prospects. This has led investors to loosely distinguish between two investing styles – growth and value.

Growth investors search for businesses they think are likely to grow. They hope to profit as the share price rises in line with improvements in the underlying business. This sometimes means paying a bit more for these perceived long-term strengths.

Value investors search for companies that appear undervalued – where they think a company’s assets or profit potential aren’t fully reflected in the share price. They hope to profit when other investors later recognise this value and the share price rises to reflect it.

However, no one overpays for investments on purpose. Only the most gung-ho growth guru would tell you to ignore valuations altogether. Likewise, the potential for a business to grow is a vital part of valuation. Even the most die-hard value investor can justify paying top dollar for the right business.

These are very loose categories. Most investment decisions involve thinking about both growth opportunities and valuation.

Nonetheless, with tens of thousands of different shares trading on stock markets around the world, we need some way of deciding which might be worth researching. Looking for businesses that fit into a rough framework can help here, because it naturally narrows down the search.

This article isn’t personal advice. If you’re not sure if an investment is right for you then you should seek advice. Remember, all investments can rise as well as fall in value, so you could get back less than you invest.

Getting good value

Classic value investing is all about aiming to get your money’s worth. Investors look at the fundamentals of a business to look for discrepancies between what a company’s really worth and its share price.

Sometimes the company will own assets like property, which aren’t reflected in the share price. Or a business might have competitive advantages that the market hasn’t realised yet. Sometimes a company will have run into problems, which value investors think the market’s overreacted to. This means the share price is lower than what they think it should be.

There are lots of different ways to value a company, but the most popular is the Price to Earnings (PE) ratio. A PE ratio is calculated by dividing a company’s share price by its earnings per share (expected earnings for a forward PE ratio).

For example, if a company earns 50p per share and its shares cost £10.00 each, it would have a PE ratio of 20.

But value investing doesn’t necessarily mean buying companies trading on low PE ratios, although it tends to be easier to find a good deal at TK Maxx than Tiffany’s. That means classic value investors will often look for shares that trade on valuations below their long run averages, or in unfashionable industries.

The table below shows the ten FTSE 100 companies with the lowest forward PE ratios. Remember, these sorts of screens are only useful as a starting point for more research. As anyone who’s ever bought a used car will tell you, a low price doesn’t guarantee a bargain.

Source: Refinitiv Datastream, 01/02/21.

These stocks tend to come from unfashionable sectors, have large fixed cost bases (miners, telecoms), or be in stodgy low growth industries (insurance). Note the lack of technology or consumer goods companies.

Low growth, capital intensive or otherwise unfashionable companies are usually a value investor’s bread and butter. Not all will be good value, but diligent investors might find gems hiding in the less exciting corners of the market.

Value investors will sometimes look at other figures, as well as Price to Earnings ratios, like Price to Book ratio and dividend yield. These are then used alongside things like how the business’s balance sheet looks, its competitive landscape and any distinctive advantages it has.

We discuss company valuations and more in our share research.

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Going for growth

Growth investors, on the other hand, look for companies that can grow their profits over time, usually the long-term.

These tend to be in growing industries, like tech is currently, where a rising tide can lift all boats, or have powerful brands or valuable intellectual property. Sometimes they might even be unprofitable, and investors will be buying for the potential. Growth stocks, perhaps unsurprisingly, all tend to show strong or more reliable sales growth, regardless of other factors.

Growth investors are normally more comfortable paying up for high quality businesses than their more value-oriented cousins.

Of course, there’s a price at which even the fastest growing companies will be overvalued. But growth investors are usually more relaxed about price and don’t insist on an exceptional price every time. They simply buy strong and promising businesses and let the power of compounding take care of the rest

Look at Unilever, for example.

Since 1999 Unilever’s PE ratio has fallen from 27.6 to 18.2, and was plenty volatile in the meantime. However, shareholders have still made a 522% return, compared to 188% for the FTSE All Share (both with dividends reinvested).

Unilever

Scroll across to see the full chart.

Past performance isn’t a guide to future returns. Source: Refinitiv Datastream, 1/2/21. Figures shown are as of 1 January each year.

This is because Unilever’s earnings per share also grew over this period, from €0.31 to €2.12. So even though the valuation actually moved in the opposite direction, shareholders did well in the long run. Of course, there’s no guarantee this performance will be repeated.

GARP & Goldilocks

The distinction between value and growth can often be fuzzy. To make things fuzzier, some investors will blend the two approaches.

Peter Lynch, one of the most successful fund managers of all time and author of the best-selling book One up on Wall Street, employed a strategy known as “Growth At a Reasonable Price” – or GARP.

Lynch focused on finding growing businesses, but kept a close eye on valuations too. This hybrid style worked well for his fund, which returned an average of 29% a year over Lynch’s 13 year tenure.

Lynch’s fusion of value and growth shows investors don’t need to pigeonhole themselves into one or the other. Each investment you make should be considered on its own merits, and don’t worry if it doesn’t fit into a pre-defined style.

Growth or value?

It might seem like the debate between growth and value means investors must pick a side to support like football fans. This simply isn’t true.

Both growth and value investing make sense, and investors have had success pursuing both strategies. Using either to narrow down the list of potential investments could be a good starting point.

In fact, we think it’s important to have some of both value and growth as part of a diversified portfolio.

This article is not personal advice or a recommendation to buy, sell or hold any investment. If investors are not sure of the suitability of an investment for their circumstances, they should seek advice. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment.

Past performance is not a guide to the future and all investments rise and fall in value so investors could make a loss.

This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing.

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