This post has been written by Phil Rebiere for Morningstar Canada, where it initially appeared.
In the U.S. and Canada, the value style of investing -- selecting stocks that are trading at a price lower than the company's intrinsic worth -- has outperformed the growth style, which is characterized by investing in companies with superior earnings prospects.
This tendency is reflected in the performance discrepancies in style-based indices. In the U.S., the Russell 1000 Value Index has returned 12.1% in U.S-dollar terms, from its December 31, 1978, inception to June 30, 2016. This is more than a full percentage point higher, compounded annually, than the 10.9% return of its growth counterpart, the Russell 1000 Growth Index.
In Canada, there has been a similar pattern, based on data compiled by providers of style-based indexes. The MSCI Canada Growth Index has delivered a total return, including reinvested dividends, of 8% since inception in December 1974, compared to 11.4% for the MSCI Canada Value Index.
Over a much shorter period, the performance gap is substantially wider between the Dow Jones Canada Select Growth Total Return Index, returning an average annual 3.7% since its inception in June 1997, and the Dow Jones Canada Select Value Total Return Index's return of 10% over the same period.
Despite these long-term results, Thierry Vallée, senior portfolio manager and head of Canadian equities at Russell Investments Canada, disputes the notion that value is a superior style.
- There is no assurance, Vallée notes, that one style will outperform the other over a particular time frame.
There will be periods when growth investing outperforms value. This was the case, for instance, in the U.S. market during the 10 years ended June 30. During that period, the Russell 1000 Growth Index returned 8.8% in U.S.-dollar terms, outperforming the 6.1% return of its value counterpart.
- Vallée says neither value nor growth investing should be seen as the true drivers of investment returns.
Instead, it is the quality of the companies held. He describes quality as the critical component of a successful business, and therefore of a successful stock-selection discipline.
Examples of quality attributes include optimal financial leverage, robust operating margins and capable managers who make sound decisions for long-term profitability. Yet, these attributes are applicable to both value and growth investing.
If quality is the driver of returns, the emphasis that value investors put on quality may be the reason for its outperformance in the long run." We believe in time, value will outperform," says Vallée. "But if you look at good growth and good value management it is not that clear-cut."
What to note about growth companies.
Strong management is often what draws investors to growth companies.
Vallée says the use of financial leverage and the allocation of earnings can be good indicators of the strength of a growth company's management.
A growth company is expected to grow faster than its peers, and will often have a high price-earnings ratio, indicating that investors are betting on future earnings expectations.
Growth companies can also pose an opportunity to make exceptionally high returns over relatively short periods of time, but with added risk. For example, one of the holdings in the Russell 1000 Growth is CVS Health Corp, which returned a compound annual 20.3% in the three years ended June 30. But over the 12 months to June 30, the stock was down 7.2%.
Growth is associated with aggressive expansion of sales and operating margins.
The risk is that highly demanding investors will put pressure on management to meet high expectations. The result is often short-sighted decision-making by management, thus sacrificing quality for growth.
One way to evaluate the quality of a growth stock is to evaluate its financial leverage. Doing so is not simply a matter of comparing the company's debt-equity ratio relative to its peers, but also determining whether its debt load (and loan maturity dates) will impede strategic growth initiatives in the future.
Inferences about the quality of a growth company can also be drawn by analyzing the use of proceeds from debt financing. Growth via acquisition is a common route taken by growth companies. But they must avoid the temptation to overextend themselves.
For example, Valeant Pharmaceuticals International Inc. increased its leverage, with long-term debt exceeding US$30 billion after an acquisition spree, which included Bausch & Lomb for US$8.6 billion in 2013 and Salix Pharmaceuticals for US$11 billion in 2015. This led to more than US$41 billion in goodwill and intangible assets on the balance sheet, which is at risk of substantial write-downs.
The deployment of earnings -- whether paid to investors, reinvested in the business or used to pay down debt -- is key for growth companies. Understanding management's tendencies, particularly in cash management, is very important.
For example, the management of a growth company may make the prudent decision to pay back high-interest debt before paying dividends to shareholders. But this, too, could be a characteristic of a value company.
Regardless of whether you tend toward the growth or value style, it's imperative that quality be the foundation of whichever style you favour for your investments.
