Whether you choose to invest in individual stocks or stock funds, you are always presented with a dilemma: should I invest in value stocks or should I stick with growth. In fact, there is a third investment style which can simplify your investment life. It is called Blend. As the name assumes, this style combines both value and growth approaches. Investor’s portfolio holds both growth and value stocks which, in addition, enhances his diversification not only among different stocks, but within investment styles as well.
What are Growth and Value stocks?
Growth stocks are stocks of companies that demonstrated above-average growth in earnings compared to the market, in general. What is more importantly, the company is expected to keep up the pace and even deliver higher levels of revenue and profit growth. Growth companies, in most cases, do not pay dividends because future cash flows are hard to predict and they tend to reinvest the profit in the business itself.
Value stocks, in turn, are stocks of well-established companies with a solid business and fundamentals. The whole idea of value investing is to find companies that are believed to trade lower than its value. Value stocks usually pay dividends (with an annual dividend yield in the range of 2-5.5%) and have low price-to-earnings and price-to-book ratios.
How to Invest?
As you can see, picking individual stocks is not an easy thing to do. Simply investing in the stocks that you are presented in numerous articles titled like “Best Stocks for 2015” or chosen by talking heads on CNBC is not an option in my opinion. You have to understand the business, the industry a company operates in, see what management and its competitors are doing, calculate and compare multiple ratios with peers. It is all extremely time-consuming and hard to do.
So, what do you do if you have no time nor skills to pick up your own stocks? The easiest and probably the best approach is to invest in mutual or exchange-traded funds (ETFs). Depending on the fund you choose to invest in (value, growth, or blend), fund manager will create a portfolio of stocks that comprise specific index and aim to match risk and return of this index. By investing like this, you may be confident that you will never underperform the market and achieve a return compared to a specific index less fund’s commission.
What Style Should You Choose?
Sometimes I get asked why my firm offers portfolios that hold both growth and value funds? Isn’t it better, efficient, and most importantly cheaper to invest in a blend? Not necessarily. Depending on investor’s goals, risk tolerance, and market conditions, it might be better to spread funds among the growth and value styles.
To see if it makes sense to invest in both styles or stick with a blend style, let’s take a look at a quick analysis I did.
Here are my settings and assumptions.
- Period: 1/1/2003 – 3/16/2015
- Market capitalization: Large
- Benchmark indices: Russell 1000 Value index as a Value proxy, Russell 1000 Growth index as a Growth proxy, and Russell 1000 index as Blend proxy.
- ETFs used to calculate net of expense ratio fees return of the portfolio: IWD (value, expense ratio 0.21%), IWF (growth, 0.2%), IWB (blend, 0.15%)
- Performance of a hypothetical $1000 investment is adjusted for expense ratios. Nominal (not adjusted for inflation)
- Standard deviation, as one of the measures of risk, is annualized
- For additional comparison, I added S&P 500 Index (SPY ETF, expense ratio of 0.09%)
Please note, that there are cheaper ETF alternatives on the market and the numbers below may vary depending on the exact expense ratio of the fund you choose.
Let’s begin with the performance first.
Starting 2003, each index have grown by an impressive 14%+ on an annualized basis (CAGR.) One obvious laggard is Value index, with an increase of 14%. An absolute leader is Growth index, with an increase of 16.9%. S&P 500 was 2% lower on an annualized basis. It may seem small, but it is a huge difference. Consider the growth of a $1,000 over this period and you will find out the outperformance of Growth index by 14.7%.
Looking at the dynamics of the curves, it is clear that there is almost no diversification benefits. Coefficient of correlation between Value, Growth, Blend, and S&P 500 is well above 0.9. Again, it is expected because indices are composed of large-cap stocks, and hence, move in one direction every time. The only big difference here (outside of the index calculation) is that S&P 500 consists of 500 companies, while Russell indices analyzed here represent a broader range of large-cap companies, 1000+ to be exact.
However, when we look at the rolling 15-month correlation, we can see that there are times, when diversification between growth and value stocks may provide benefits. But these periods are very rare and not significant to count on them in the future.
Now, let’s dive into risk analysis. This is the most important part not only of this article, but of the investing process, in general. No matter how terrific returns look like, if they assume too much risk – you are better to stay away. Unless, you are cruising for a bruising.
I measure risk using multiple measures, but the most important for me are maximum drawdown and standard deviation. Maximum drawdown measures the depth of the decrease in equity from its recent peak to trough (before a new beak is achieved). The bigger it is – the worse it is. Standard deviation is a measure of historical variability that defines the range in which the price may fluctuate with N% confidence.
The result that we can draw from our risk analysis is the following. Maximum drawdown was achieved in 2009 during the financial collapse. However, an interesting fact that we can notice from the image is that Growth index experienced the lowest maximum drawdown, -39.8%. A cold comfort for the almost 40% decrease in value, but all the same. Taking into account an average drawdown and standard deviation, we can see that Growth index was, in fact, the riskiest. However, in my opinion, the increase in return is adequate to compensate for the additional risk.
So far, we’ve seen that since 2003 Growth index seems to be the best performer, less correlate with the Blend Index and S&P 500, and have the least risk, as measured by the maximum drawdown.
Does it mean that it is going to be the best performer in the future? Should you invest solely in the growth stocks or growth funds based on the information above? Absolutely not. Multiple research shows the growth stocks are in fact the worst performing stocks and you are much better off by investing in value stocks (for example, check out this article).
Investing is a dynamic process. Things can change very quickly. In the past, value stocks have been performing better. Today growth stocks show signs of outperforming. What is going to happen in the future nobody knows. For the time being, I will keep my current portfolios structure and diversify among both investment styles.