Many investors are loyal to either a value-investing style or a growth-investing style, but there is lot to be said for tossing aside that kind of loyalty and siding with a winner.
And right now, growth investing looks like the best option, at least among U.S. stocks, given the direction of interest rates and the flow of dividends.
The two styles carve up stocks into two categories, based largely on earnings expectations and valuations.
Value stocks grow their earnings at a slower pace, but they're cheaper based on price-to-earnings and price-to-book ratios. Conversely, growth stocks grow their earnings at a faster pace, but they tend to be more expensive, using popular valuation ratios.
These days, companies such as Apple Inc. and Google Inc. top most growth-stock lists, while General Electric Co. and Johnson & Johnson generally dominate the value team.
Value investing has tended to deliver better results over the long term, but growth investing has its moments. Since the onslaught of the global financial crisis in 2007, growth stocks have outperformed value stocks by more than 30 per cent, according to strategists at Pavilion Global Markets, underscoring how much is at stake in getting this call right.
The strategists expect the outperformance to continue, despite some wobbling so far this year.
They looked at how the two styles performed during periods of spiking bond yields, which defines today's environment. The yield on the 10-year U.S. Treasury bond is now approaching 2.9 per cent, up from just 1.63 per cent in May.
Since 1973, growth stocks have outperformed value stocks, on average, when government bond prices fell – driving yields higher – by 2 per cent or more over a period of four months. The average performance difference in favour of growth stocks is 3.2 per cent after three months, stretching to 7.7 per cent after nine months.
"History tells us that growth usually outperforms in a rising yields environment," the Pavilion strategists said in a note.
As well, growth stocks have been raising their dividends at a faster pace than value stocks – an interesting switch given that value stocks, on average, have heftier quarterly payouts.
A large part of the explanation comes from the fact that financials, which are usually associated with value investing, have disappointed investors with their dividend hikes.
Payouts from financials have been rising for about two years, but remain 32 per cent below their pre-recession highs – dragging down the attractiveness of value investing from a dividend perspective.
If growth stocks continue to outshine value, how can investors play the trend? The easiest way is to invest in an exchange-traded fund that tracks stocks that have been given the growth label.
The Vanguard Growth ETF and the iShares S&P 500 Growth index provide exposure to large-cap stocks – although the two funds can't agree on whether Microsoft Corp. and Exxon Mobil Corp. are growth or value stocks. The iShares ETF thinks they're both growth stocks while Vanguard pegs them as value stocks. (Both fund providers provide value ETF counterparts.)
For smaller stocks, there is the iShares Morningstar Small Growth index and the Vanguard Small-Cap Growth ETF.
For sure, many investors have an investing style that defines their portfolios, making any shift between value and growth feel like a betrayal. But given that value and growth tend to perform differently with a shifting investing climate, being a free agent has its rewards.
David Berman