What do equity managers mean when they discuss growth versus value? The answer is not as intuitive as it seems. While a stock can transition from growth to value and back again throughout its life cycle, the two styles offer distinguishing characteristics, and like small versus large cap, play distinct roles in asset allocation. Though fund managers can debate the merits of each style, ownership does not need to be mutually exclusive. Understanding the behavior of growth and value across market cycles can inform appropriate asset allocation.
Growth stocks typically exhibit above average or accelerating profitability growth. In mathematical terms, their growth is captured in two stages: hyper and terminal. Unsustainably high growth characterizes the hyper stage, while the terminal stage exhibits slower but persistent growth. A growth investor attempts to determine the length of the hyper stage, as well as how high the market will support valuation as that hyper stage slows. Value stocks, by contrast, have theoretically already slowed to their terminal growth rates. A value investor wants confidence in persistent cash flows supported by terminal growth.
Though money managers can employ various techniques to evaluate stocks, determining a stock price as a multiple of sales, operating profit, and earnings is common practice. Growth stocks typically trade at lofty price-to-sales (P/S), enterprise value-to-earnings before interest, taxes, depreciation & amortization (EV/EBITDA), and price-to-earnings (P/E) multiples. What do these metrics imply? Such multiples significantly exceed market averages, reflecting a consensus belief that a company’s exorbitant growth is sustainable and suggests the company will grow into its high multiple over time.
Because they may have already reached their terminal growth rates, value stocks tend to trade at or below market multiples. Unlike growth, value stocks may deploy much of their capital via dividends, supported by excess cash. Growth stocks, meanwhile, are likely to reinvest all or most of their cash into their business, targeting labor, technology, stores, and equipment, to support continued growth. Because growth stocks pay little to no dividend to shareholders, a growth manager seeks return through capital appreciation only. A value manager instead seeks total return: the dividend payout and the change in stock price over a given period.
In a sense, growth companies are innovators while value companies are incumbents, though nothing precludes an incumbent from innovating. Though incumbents may face periods of stagnation and at times trade as value stocks, their continued ability to innovate should perpetuate their market dominance and support growth characteristics. With the success of its cloud computing platform, Azure, Microsoft reinvented itself beyond personal computing. The advent of the iPhone revived Apple, which had previously struggled with declining Macintosh sales. Non-technology companies Starbucks, NextEra (formerly Florida Power & Light), and Eli Lilly likewise found paths to renewed growth via mobile ordering, renewable power, and tackling obesity. Conversely, innovators may lose their edge: PayPal traded at 55 times forward earnings (versus the market at 22 times) just two years ago; today it trades at 12 times, well below the market at 18. Other companies, like Verizon and AT&T, may have simply reached terminal growth.
Whether growth- or value-based, innovation nonetheless spurs corporate impact that can help address society’s greatest challenges. Similarly, both growth- and value-styled companies should incorporate environmental, social, and governance criteria in their business models and offer both financial and non-financial transparency around strategic goals like carbon emissions reduction, human capital empowerment, and materials sourcing. Such transparency helps all investors—regardless of whether they seek differentiation through integration of ESG criteria—to better understand the long-term power of their investment.
Understanding the differences between growth and value is critical to contemplating the ongoing argument about which investing style is better. The performance of value funds dominated growth from 1970 until early 2007. Arguably a byproduct of unprecedentedly easy monetary policy following the 2008 financial crisis, growth went on to outperform value throughout the darkest days of Covid-19’s global lockdown. Excluding a rotation back to value in 2022, growth investing continues to outperform value today. The reasons for this outperformance are debatable, though market narrowing around the largest technology companies may hold a clue, especially as pundits contemplate the likelihood of a US recession.
Growth and value both deserve places in multi-asset portfolios, with an astute investor tilting toward one style and away from the other depending on market dynamics. Trending markets, like those we have witnessed over the last decade, may favor a heavier weighting to growth, while oscillating markets may support value. Irrespective of short-term market behavior, a retiree seeking additional dividend income may prefer a greater allocation to value, while a young professional may feel confident in the capital appreciation growth affords. For its part, Boston Common’s strategies express a value bias, reflecting the firm’s philosophy for high quality, cash generative, solutions-oriented companies that remain reasonably priced. A nod to capital preservation, this philosophy still allows for agility to exploit current and anticipated market sentiment.