VALUE VERSUS GROWTH INVESTING

Elaborated by:

Zineb CHERKAOUI

ABSTRACT

In the context of stock investing, we can distinguish between two types of the most common investment: growth and value. They represent labels that are routinely applied to individual stocks, market sectors, indexes, investors and also mutual funds. Many academic research literatures have been provided in order to discuss the performance of value versus growth leading to various explanations of this empirical research that have been reviewed and updated. Thus, most of researches show that value investing outperforms and generates superior returns. The example of IBM is given to show how some companies change their investing style and the causes that lead to do so.

PLAN:

I- EXECUTIVE SUMMARY..3

II- INTRODUCTION5

III- VALUE VERSUS GROWTH INVESTINGIII- 1- VALUE INVESTING- Definition of value stocks.7- Criteria for assessing Value stocks....8- Risks in Value stocks8III- 2- GROWTH INVESTING Definition of growth stocks....9 Criteria for assessing Growth stocks...9 Risks in Growth stocks.....11III- 3- MAJOR DIFFERENCES BETWEEN VALUE AND GROWTH STOCKS.12

IV- LITERATURE OVERVIEW..12V- EXAMPLE OF COMPANIES...15VI- VALUE OR GROWTH WHICH STYLE IS BETTER?........................16VII- RECOMMENDATION...19VIII- CONCLUSION20IX- REFERENCES...21

EXECUTIVE SUMMARY

In practice, there are as many investment styles as there are investors. Most professional money managers, whether they prefer growth or value or something in between, use elements of both styles in their investment research. Every value manager wants growth: thats the reason we all invest in the first place. Every growth manager wants value: to invest otherwise would be pure speculation. What varies among managers is the emphasis they place on value or growth. Indeed, many money managers prefer the middle ground, sometimes called a blend, or core strategy.The distinction between the two investing styles stems from a difference in perspective. Value investors usually start by measuring a companys intrinsic worth: What is the stock worth based on the companys current value, regardless of what the stock price indicates? Growth investors tend to look more at the companys prospects: Is it growing and how fast? How long can it continue its growth? These are only the rough starting points. As value and growth investors perform their research, they use a wide variety of indicators to judge a stocks prospects. They also tend to use some of the same measuring sticks. In fact, most value managers pay at least some attention to companies growth rates, and most growth managers look hard at price.

INTRODUCTION

Diversification of investment styles is a new buzzword in the field of portfolio management even though the concept has a long history in financial economics. The style is the strategy used by a portfolio manager to get a better return than the stock market indices. The two main styles of portfolio management are "value" and "growth." Here we look at how the use of these two styles of investment management can help us get a better return for our portfolios.Diversification is the cornerstone of any strategy for long-term investment because it reduces risk and maximizes performance. You can reduce the fluctuation of annual yield of your portfolio by investing in asset classes whose values respond differently to the same economic conditions.Many ways are used to assess and get informed investing styles. Several best-selling books, business magazine articles are available to help investors and concerned parties to look for and choose the best value funds and/or the best growth funds. Some others are educated about the investing styles already in business school like Wall Street professionals, with courses on Value investing and growth investing.These educating institutions teach more importantly the perspective of academic researches discussed and debated between many researchers many years ago. The most debated issues concern the differential returns of investments in value versus growth stocks portfolios. The most popular researches and arguments were provided by Fama and French, Lakonishok, Shleifer, and Vishny and Basu. They all focussed their attention on value and growth investing giving arguments of which one is more efficient and profitable. However, very little researches explain the determinants of an individuals investment style which means the reasons why some investors are value oriented while others are growth oriented. This brought us to opt for the following plan: In this paper, we will explain first value and growth stocks in general and then outline the major differences between the two styles. We will also discuss which style is generally preferred and in which way one outperforms the other which means in other words the the main factors that makes it more preferable. In a second part we will discuss the findings by going back into history and seeing results of the various researches that were conducted on the topic by seeing how they were updated during all this period. Finally we will discuss an example of a company using value versus growth concepts, showing for what reasons they choose their investing style and on what does it depend.

III- VALUE VERSUS GROWTH

III- 1- VALUE STOCKS/ VALUE INVESTING

WHAT ARE VALUE STOCKS/VALUE INVESTING?

Value investing is an investment paradigm that derives from the ideas in the book, Security Analysis, which was written by Ben Graham and David Dodd in 1930s. They argued that the long-term returns could be achieved expectedly by investing in stocks what are bargains compared to their intrinsic value. Warren Buffett, Berkshire Hathaway chairman is a high-profile proponent of value investing; he has argued that the essence of value investing is buying stocks at less than their intrinsic value. That means value stock is like a bargain, it is a stock which its current stock price is lower than the value of the company, it has potential to become a growth stock in the future. The investor can buy it with a low price. We also have to know that value investing does not mean buying any declines and it seems cheap in the price, therefore, the investors have to do some research as much as possible to ensure they are choosing a corporation which is not expensive given its high quality, not a company simply has a cheap price. If it is real bargain then it must has a very healthy fundamental to prove that it is worth more than its current stock price. Moreover, the value investing always compares its current share price to intrinsic value not to its historical share price. Besides, its quite important to know that when the investors are picking a value stock, what they are doing is buying a business, not only a stock. They will not pay attention to external factors which are affecting the company, because those factors will not have influence on the value of the company in long-term. However, though it has a lower rate of growth in earnings/sales, low price/earnings and price/book ratios, higher dividend yields and turnaround opportunities, it still has some risks like its difficult to stick to value policy when the prices are beaten down and the evaluation of it as good value is misread. In a word, the value investing style can be viewed as a conservative investing style; they choose companies with high intrinsic value but low price, which can reduce investment risk if in a worst-case scenario. They are like taking a long-term perspective on their investments.

CRITERIA FOR ASSESSING VALUE STOCKS

1. The price earnings ratio (P/E) should be in the bottom 10% of all companies. 2. A price to earnings growth ration (PEG) should be less than 1, which indicates the company is undervalued. 3. There should be at least as much equity as debt. 4. Current assets at twice current liabilities. 5. Share price at tangible book value or less.

RISKS IN VALUE STOCKS

Value funds focus on companies with lower-than-average sales and earnings growth rates. Holdings generally feature stocks with lower price-to-earnings and price-to-book ratios. Stocks generally have higher dividend yields. Fund can potentially capitalize on turnaround situations. However, market may have correctly priced underlying companies, in which case they may never realize their intrinsic value; that is the evaluation of stocks as good value is misread. Sometimes also it becomes difficult to stick to value policy when prices are beaten down.

III- 2- GROWTH STOCKS/ GROWTH INVESTING

WHAT IS GROWTH STOCKS/ GROWTH INVESTING STYLE

Growth investing is a style of investment strategy. Unlike value stock, the investor will find companies whose earnings are expected to grow faster than the broad market, in other words, they will buy companies that are trading higher than their current intrinsic worth, but they believe that buying companies whose earnings are growing faster than average is the best way to get a return, it means the growth stock has good profitability and it can help the investor earn more net income with less equity. The growth investors prefer to be less price-sensitive, they will analyse the companies to determine whether it can increase its earnings in the future. If it is, they dont mind its high current price cause it will become a bargain one day. Due to the growth stocks are the companies that grow substantially, so that the investors may pay more attention to identify potential catalysts for its growth, such as new product, new markets or new technology. Whats more, compared to value investing style, the growth investing style is seems considered more aggressive, and the investors prefer to be less patient with what they are holding. If the stock does not grow any more as expected, they can sell it without hesitation. In addition, the growth stocks have high rate of growth in earnings/sales, high price/earnings and price/book ratios and you can pay lower or no dividends, but it will also has some risks, its future growth does not come as what you expected or the price/earnings, price/book ratios decline unexpectedly. Thomas Rowe Price, Jr. has been called the father of growth investing.

CRITERIA FOR ASSESSING GROWTH STOCKSThe National Association of Investors Corporation (NAIC) is one of the best known organizations using and teaching the growth investing strategy. It is, as it says on its website, "one big investment club" whose goal is to teach investors how to invest wisely. The NAIC has developed some basic "universal" guidelines for finding possible growth companies - here's a look at some of the questions the NAIC suggests you should ask when considering stocks.

1. Strong Historical Earnings Growth? According to the NAIC, the first question a growth investor should ask is whether the company, based on annual revenue, has been growing in the past. Below are rough guidelines for the rate of EPS growth an investor should look for in companies of differing sizes, which would indicate their growth investing potential:

Although the NAIC suggests that companies display this type of EPS growth in at least the last five years, a 10-year period of this growth is even more attractive. The basic idea is that if a company has displayed good growth (as defined by the above chart) over the last five- or 10-year period, it is likely to continue doing so in the next five to 10 years.

2. Strong Forward Earnings Growth? The second criterion set out by the NAIC is a projected five-year growth rate of at least 10-12%, although 15% or more is ideal. These projections are made by analysts, the company or other credible sources.

The big problem with forward estimates is that they are estimates. When a growth investor sees an ideal growth projection, he or she, before trusting this projection, must evaluate its credibility. This requires knowledge of the typical growth rates for different sizes of companies. For example, an established large cap will not be able to grow as quickly as a younger small-cap tech company. Also, when evaluating analyst consensus estimates, an investor should learn about the company's industry - specifically, what its prospects are and what stage of growth it is at. (See The Stages of Industry Growth.)

3. Is Management Controlling Costs and Revenues? The third guideline set out by the NAIC focuses specifically on pre-tax profit margins. There are many examples of companies with astounding growth in sales but less than outstanding gains in earnings. High annual revenue growth is good, but if EPS has not increased proportionately, it's likely due to a decrease in profit margin.

By comparing a company's present profit margins to its past margins and its competition's profit margins, a growth investor is able to gauge fairly accurately whether or not management is controlling costs and revenues and maintaining margins. A good rule of thumb is that if company exceeds its previous five-year average of pre-tax profit margins as well as those of its industry, the company may be a good growth candidate.

4. Can Management Operate the Business Efficiently? Efficiency can be quantified by using return on equity (ROE). Efficient use of assets should be reflected in a stable or increasing ROE. Again, analysis of this metric should be relative: a company's present ROE is best compared to the five-year average ROE of the company and the industry.

5. Can the Stock Price Double in Five Years? If a stock cannot realistically double in five years, it's probably not a growth stock. That's the general consensus. This may seem like an overly high, unrealistic standard, but remember that with a growth rate of 10%, a stock's price would double in seven years. So the rate growth investors are seeking is 15% per annum, which yields a doubling in price in five years.

RISKS IN GROWTH STOCKSGrowth funds focus on companies with above average rates of growth in earnings and sales. These stocks tend to have above-market price-to-earnings and a price-to-sales ratio, as the rapidly growing sales and earnings justifies a higher-than-average valuation. However, growth may not always be realized. Price-to-earnings or price-to-book ratios may decline due to unforeseen events.

III- 3- MAJOR DIFFERENCES BETWEEN VALUE AND GROWTHEvery investor has their own specific definitions of Value and Growth stocks. However there are some broad classifications that are accepted by most which provide a basis of distinction between the two. Typically, Growth stocks have relatively high P/E ratios and P/B ratios, whereas Value stocks usually have relatively low P/E ratios and P/B ratios. Secondly, Growth stocks typically grow earnings/revenues faster than the industry/market and Value stocks are said to be currently trading at a discount to their true value. Lastly, Growth stocks rarely pay dividends, as they prefer to reinvest the excess cash for further growth, and Value stocks generally have high dividend yields.

IV- LITERATURE OVERVIEW

Value and growth investing is a topic resulted from a great exchange of ideas, deep academic researches and interesting investment practices. Widely applied investment strategies in equity markets are generally the result of some academic interests that were traced back to Fama and French (1992), Laknishok, Shleifer and Vishny (1994), Basu (1991), and some other academic findings.IV- 1- The academic researches results

The results of Fama and French (1992) delivered a stunning blow to the explanatory power of the Capital Asset Pricing Model, and sparked debates about the death of beta. They take the position of the Efcient markets hypothesis, and attribute the higher returns of value strategies to their increased risk (argue that stocks with high ratios of book equity to market value are more prone to nancial distress and hence riskier). They compared value to growth stocks by considering companies with low price-to-book ratios representing value stocks to companies with high price to book ratios representing growth stocks. The results showed that on average, value stocks were outperforming. The value stocks provided greater potential returns than growth stocks during 1991-2010 and this performance were estimated by 0.46% per month. They created a set of growth and value data dating back to 1928, and the two used book-to-market ratios to define growth and value. And their study produced a clear winner (data through 2004)Large Value: 11.9%Large Growth: 9.2%Small Value: 14.9%Small Growth: 9.6%There were years in which growth outperformed value, however, over the long term, value triumphed, particularly small cap value stocks.Lakonishok, Shleifer and Vishny (1991) studied the Japanese data and nd strong support for the superior performance of value investment strategies. They also suggest that cognitive biases underlying investor behaviour and the agency costs of professional investment management are at the root of the rewards to value investing. They argue against this metaphysical approach to risk, for them risk does not explain the differences in returns. To develop the point they used two signals: cash ow to price and past growth in sales, which helped to lower the chance of misclassifying stocks into value and growth categories. A stock with high cashow per dollar of share price, as well low past growth in sales, is more likely to be a value stock with low expected future growth. In comparison investors are more prone to regard a stock with low cash ow relative to price and high past sales growth as having more favourable future growth prospects.Basu (1977) showed that stocks with low price-to-earnings ratios subsequently tend to have higher average returns than stocks with high ratios.Academics shifted their attention to the ratio of book-to-market value of equity, and rm size as the leading explanatory variables for the cross-section of average stock returns. This work built on earlier studies of stock market anomalies.

ReturnThe academic community has generally come to agree that value strategies on average out-perform growth investment strategies. There is much less consensus, however, on the underlying reasons for the superior returns.

IV- 2- Fama and French Three Factor ModelFama and French attempted to better measure market returns and, through research, found that value stocks outperform growth stocks; similarly, small cap stocks tend to outperform large cap stocks. As an evaluation tool, the performance of portfolios with a large number of small cap or value stocks would be lower than the capital assets pricing model (CAPM) result, as the three factor model adjusts downward for small cap and value outperformance.It is a factor model that expands on the capital asset pricing model (CAPM) by adding size and value factors in addition to the market risk factor in CAPM. This model considers the fact that value and small cap stocks outperform markets on a regular basis. By including these two additional factors, the model adjusts for the outperformance tendency, which is thought to make it a better tool for evaluating manager performance.

There is a lot of debate about whether the outperformance tendency is due to market efficiency or market inefficiency. On the efficiency side of the debate, the outperformance is generally explained by the excess risk that value and small cap stocks face as a result of their higher cost of capital and greater business risk. On the inefficiency side, the outperformance is explained by market participants mispricing the value of these companies, which provides the excess return in the long run as the value adjusts.

V- example: ibm case

Some companies alternate between being a value company and a growth company. A good example of this is IBM. Throughout the late 1970s and 1980s, IBM was a popular growth company with expanding earnings growth. After a series of missteps in the early 1990s, IBM became a fallen angel (a once dominant company fallen on hard times) and more of a value-oriented company. IBM turned around in the mid to late 1990s to once again become a popular growth company. While there are companies (like IBM) that can experience changes in value and growth investment styles, most companies and industries stay in one style. Below are some examples of value and growth industries. Typical Value and Growth IndustriesVALUEGROWTH

Financial ServicesTechnology

EnergyHealthcare

UtilitiesTelecommunications

CyclicalBiotechnology

VI- Value Or Growth Which Style Is BETTER?There is no concrete answer to this question. Both value investing and growth investing have ardent supporters. The value and growth styles have performed similarly; but for longer time periods, value investing seems to have an edge. The growth style has performed better for shorter time periods. The tables below show the performance of value and growth stocks during the period of 1975-2006. They reflect the outperformance of value stocks in some periods and also of growth stocks in others. This means that value stocks are not always the most performing and preferable. However, if we see the total time period we will notice that value stocks are better than growth stocks. This is depending on both charts which shows that the average annualized returns for the total time period of 1975-2006 were 14,61% for value stocks while it is 12,07% for growth stocks.

Because the growth and value styles both go through good and bad times, there is no clear answer to which is better. Growth proponents will point to the explosive performance growth stocks cam experience. Value proponents will point to the steadier long-term returns of value stocks.Growth and value arent the only two methods of investing, but they are a way investors make a cut at stocks for investing purposes. Historically, there have been periods such as the late 1990s when growth stocks have done well and other periods when value stocks outperformed. Your best bet is to hold both for true diversification. The idea of growth investing is to focus on a stock that is growing with potential for continued growth while value investing seeks stocks that the market has under-priced and have the potential for an increase when the market corrects the price. Every investor is different. How you choose to construct your investment portfolio depends on many factors, including your time frame, your financial goals, your needs, and your tolerance for risk. Many people believe their tolerance for risk is high when the markets are booming. Conversely, many insist they have a major phobia against risk when markets are rocky. The truth usually lies somewhere in between. Since volatility and risk will never disappear, one of the best ways to come to terms with risk is through diversification. Allocating your portfolio between value and growth styles is a simple way to diversify. By doing so, you can attempt to smooth out volatilitys rocky road by seeking the benefits of both investment styles.

VII- TIPS FOR INVESTING IN VALUE AND GROWTH

1. Diversify into both styles: As we have already seen in the diagrams above that value and growth stocks perform quite differently, with each investment style going through good and bad times. By having money in both, you avoid being out when one style is hot and will not have to guess when one style will outperform the other.

2. Do not try to time the value and growth cycles: There is no discernible pattern of when value or growth dominates. On average it seemed from the patterns of the past that just about every year the cycle should change, but that is not the case. Growth dominated in the mid to late 1990s; while value dominated in the 1970s and 1980s.

3. Rebalance your investments: Investors should make sure they are invested according to their original plan and should rebalance their investments at least annually. For example, if your original goal was to invest 50% of your money in value and 50% in growth and value stocks are up 10% this year while growth stocks lose 10%, then your allocation after the year would be 55% value and 45% growth. You will need to shift 5% of value to growth to be in line with your original plan.

VIII- RECOMMENDATION

One of the solutions to the dilemma faced with using value or growth investing styles is to adopt the use of blended funds. Funds that invest in both growth and value stocks are called blended funds. Blended funds tend to exhibit many of the characteristics of both growth and value fundspotential for capital appreciation, current income, low price/earnings ratios, as well as stocks that often reinvest revenues back into business operations. Many managers of blended funds pursue a strategy known as Growth at a Reasonable Price (GARP). Managers of these funds tend to focus on growing companies, but are also highly value conscious paying close attention to traditional value indicators like the price-to-sales, price-to-earnings, and price-to-growth ratios to ensure they are reasonable.The GARP strategy is a combination of both value and growth investing: it looks for companies that are somewhat undervalued and have solid sustainable growth potential. The criteria which GARPers look for in a company fall right in between those sought by the value and growth investors. Below is a diagram illustrating how the GARP-preferred levels of price and growth compare to the levels sought by value and growth investors?

GARP investing was popularized by legendary Fidelity manager Peter Lynch. While the style may not have rigid boundaries for including or excluding stocks, a fundamental metric that serves as a solid benchmark is the price/earnings growth (PEG) ratio. The PEG shows the ratio between a companies a companys P/E ratio (valuation) and its expected earnings growth rate over the next several years. A GARP investor would seek out stocks that have a PEG of 1 or less, which shows that P/E ratios are in line with expected earnings growth. This helps to uncover stocks that are trading at reasonable prices.In a bear market or other downturn stocks, one could expect the returns of GARP investors to be higher than those of pure growth investors, but subpar to strict value investors who generally purchase shares at P/Es under broad market multiples.GARP might sound like the perfect strategy, but combining growth and value investing isnt as easy as it sounds. If you dont master both strategies, you could find yourself buying mediocre rather than good GARP stocks. But as many great investors such as Peter Lynch himself have proven, the returns are definitely worth the time it takes to learn the GARP techniques.

IX-CONCLUSION

Because the growth and value styles both go through good and bad times, there is a need to educate investors about the differences between value and growth investing. However, over the long term low-P/E stocks (value stocks) out do high-P/E stocks (growth stocks). That's because growth stocks are more prone to collapse after bad news. Over the long term value triumphs growth. (Dreman, 2005) Because value and growth companies perform so differently from year to year, it is a good idea for investors to invest in both types of companies and not try to guess which investment style will outperform the other from year to year.

X- REFERENCES Basu S (1977), Investment Performance of Common Stocks in Relation to Their PriceEarnings Ratios: A Test of Efficient Market Hypothesis, The Journal of Finance, Vol. 32, No. 3, pp. 663-682.

Bourguignon, F. f. (Summer2003). Value Versus Growth. Journal of Portfolio Management, Vol. 29 Issue 4, p71-79. 9p. Dreman, D. (2005, April 18). Value: the Best Bet. Forbes, pp. Vol. 175 Issue 8, p246-246. 1p. . Fama, F. Eugene and French R. Kenneth, (1992), The Cross- Section of Expected Stock Returns. Journal of Finance, Vol. 47, pp. 427 465.

Moskal, M. B. (Spring2002). Value or Growth Investing--Which Is Best? Journal of Pension Benefits: Issues in Administration, Vol. 9 Issue 3, p72. 3p. Lakonishok, J., A. Shleifer, and R.W. Vishny, (1994), Contrarian Investment, Extrapolation, and Risk. Journal of Finance, 49, 1541 1578.

Sharma, R., & Mehta, K. (Apr-Jun2013). Fama and French: Three Factor Model. SCMS Journal of Indian Management, Vol. 10 Issue 2, p90-105. 16p. 6 Charts, 3 Graphs. . W. Scott Bauman, C. M. (March/April 1998). Growth versus Value and Large-Cap versus Small-Cap Stocks in International Markets. Financial Analysts Journal, Vol. 54 Issue 2, p75-89. 15p. 9 Charts. 2008 Palgrave Macmillan, 1470-8272 www.palgrave-journals.com/jam/ Vol. 9, 5, 347358 Journal of Asset Management

BERNSTEIN DISCIPLINED-STRATEGIES MONITOR DECEMBER 2007

Financial analyst journal - Value and growth investing (January/February 2004)

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