Are you a Value Investor or a Growth Investor?

09/08/2021   |   Wealth Matters for Dental Professionals

Which investment style is right for you in the post-pandemic world?

After coming through the whip-saw stock market of March 2020, most investors have generally seen a rise in their portfolio value. In many cases those returns are some of the best we have seen in a decade of a generally rising bull market. Consider that the TSX in Canada returned 42% for the 12 month period April 1, 2020 to March 31 2021!

While this rising tide has definitely floated all boats……not everyone has experienced the same returns. In particular, we turn our attention to Growth vs. Value stocks:

 

A Value Stock

This is a company whose stock-price bears a direct relationship to its recent and near-term profit levels. Owning a stock is simply a right to current and future profits of that company. If you are sure that a company is going to make $1.00 every year, for every share you buy… forever… how much would you pay for it? This is the domain of value-investing. If we take a stock like Canada’s largest (most days) – RBC – we are normally able to predict within a fairly tight range what the profit will be in the coming year, we will know how that relates to last year and we will likely assume that a similar historic growth pattern will continue next year. So then… if it made $1.00 last year and it is likely to make $1.10 this year and $1.21 next year… and so on… we can use math to calculate what the stock price should be today. If the current stock price is lower than our calculations, it represents good value, which would trigger a purchase for value-investors. If the stock price is higher, it might be time to sell the stock that has become over-valued.

 

A Growth Stock

This is where the glamour lies! Facebook, Amazon, Shopify, Tesla!!!! In some of these cases there have been years with tremendous growth in the stock-price with no profit to speak of. Shopify, the darling of the Canadian market through the pandemic, didn’t have its first quarterly operating profit in its history until September 2020 ($50 million). And at one point it had a higher total company value than RBC which made $3.2 billion for the same quarter! With no profit or seemingly no direct relationship of profit to stock price, a value investor gets a headache trying to figure out whether these stocks are ever a good deal. A growth investor instead trades on momentum. As the business adds new users or hits new revenue targets or gains market-share or acquires competitors, the market becomes impressed with the growth or momentum of the company. While eventually this momentum will turn into future profit, that’s not our concern today. Will the company continue to surprise with growth of other key metrics like revenue? One could argue that Canopy Growth, Canada’s largest cannabis company, started out as growth stock….until the momentum failed to materialize.

The market of the last 5 years has treated Value and Growth investors quite differently. If your portfolio did not include Facebook, Amazon, Apple, Netflix, Google, Tesla or Shopify, your returns will be well below the performance of the general market. In 2020, the so-called FAANG stocks all had rates of return between 31.2%(Google) and 82.1%(Apple), whereas the total return for the entire market was a much lower 16.3%.

With whispers of rising interest rates, however, the tide has started to change. Value investors have seen their bargain-hunting rewarded with huge gains for the Canadian banks in recent months. These value stalwarts of the Canadian market had lagged many other sectors for all of 2020. Rising interest rates make growth investors very nervous….for a couple of reasons:

Much of the growth frenzy is fueled by the incredibly cheap cost of borrowing money. If borrowing becomes more expensive, maybe the incredible run is coming to an end?

If interest rates are going higher… I need a greater reward to own a company whose profit doesn’t justify its price. Put another way – if the interest paid on other investments in the marketplace is rising, I will similarly demand a greater return from all my investments. It is very difficult for a wildly growing growth company to grow even faster to compensate.

As a result we have seen the stocks of high-flying technology companies sell-off despite some of them finally reporting the record profits that the momentum was supposed to finally deliver. As of March 31, 2021, Shopify was down 11.5% from its peak on February 12, 2021 despite its profit doubling to $118M during the 1st quarter.

While growth stocks delivered better returns through 2019 and 2020, it is always a riskier proposition when these returns aren’t justified by underlying profit. As stock prices soar relative to the weaker underlying profit, the risk becomes exponential if a growth company falters (think Blackberry or Nortel). With Value investing there is always a mathematical underpinning based on profit.

Growth has more risk… so it should deliver more return in some years. Value investing should deliver less risk… so it will be surpassed in some years by a more adventurous growth philosophy. A classic Tortoise and the Hare.

 

Rate of Return for Selected Growth and Value Stocks