What Are the Best Stocks to Invest in: Growth or Value?
Which stocks are better, growth or value? The empirical evidence points to a conclusion that may come as a surprise to you.
Over the past 15 years, different research have been carried out that indicate to value stocks as generating better annualized gains than growth stocks by as much as 7.6 percent . Who conducted the research, and what findings did they come up with?
Value Stocks Outperforming Growth
Two high-profile studies evaluated investing techniques over a same time period, from the mid-70s to the mid-90s, and found that they performed similarly. The first group, generally known as Fama and French, analyzed value stocks versus growth stocks. In their 1997 work titled, Value Versus Growth: The International Evidence?, Eugene F. Fama and Kenneth R. French describe a value stock as follows:
- Price-to-book ratio is quite low.
- A low price-to-earnings ratio (P/E ratio).
- Low price-to-cash-flow ratio
- Price to dividend is at an all-time low.
Note: If you invert the equation, book to price ratio for instance, then higher is better for selecting value stocks.
The study discovered that value stocks beat glamor or high-growth stocks an average of 7.6 percent per year. Joseph Piotroski, a researcher who worked on a paper titled Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, published in 2000, came to the same conclusions as Piotroski. With his value portfolios, he was potentially able to produce annualized gains of more than 23 percent.
Does this suggest that we should avoid growth stocks? No, and the following are some of the reasons why.
Investing in High-Growth Opportunities
Always remember that we are talking about large groups of averages with nothing in the way of qualitative investigation. Based on numerical stock screens, you can classify stocks into growth or value. The research looked at broad averages rather than specific figures. But many growth stocks are able to produce extraordinarily abnormal returns, such as Apple expanding from $7 in 2003 up to over $350 today.
If you are a really careful investor who has the capacity to recognize promise in tiny businesses, high-growth investing may provide you with some extremely large returns on your investment. Many small businesses, on the other hand, are unable to obtain finance or are crushed by the industry's largest corporations. The delisting of companies that go bankrupt will have a significant impact on the average growth of high-growth portfolios.
When compared to trading averages, value investing has been shown to produce higher annualized returns. If you have a flair for choosing winners within a collection of potentials, high-growth stocks still have much glitter. However, there is another factor to consider when comparing value and growth.
The Link Between Stocks and Market Cycles
In 2003, Yul W. Lee and Zhiyi Song released a report that showed the association between value and growth stocks and the market cycles. What did they uncover in the paper titled, When do Value Stocks Outperform Growth Stocks? What is the relationship between investor sentiment and equity style rotation strategies? First and foremost, we must grasp the fundamental concept of the put-call ratio.
This ratio compares the quantity of put options contracts that are sold in the market to the amount of call options contracts that are sold. Put options gain in value when the stock market falls, and call options gain in value when the stock market rises, as shown in the chart. By examining the put-call ratio, you can immediately gauge the mood of the market's investors.
- If the ratio is high, it indicates that investor sentiment is negative.
- If the ratio is low, it indicates that investor mood is positive.
The study article revealed that when investor sentiment is strong, as shown by a low put-call ratio, growth stocks tend to beat value stocks. Perhaps this is because growth stocks are perceived as having a bigger upside, so traders flock to them when the pastures appear green. In practically every other market nevertheless, value stocks appear to outperform.
A definite winner in the world of value and growth investing?
This argument, in my opinion, is far from ended. Overall, value outperforms the market, especially when looking at broad averages. In some markets, growth has the upper hand. Still, with the vast number of abnormal returns in high growth investment, if researchers were able to identify the winning measures of these rocket stocks, the tables would flip once again. At this time, the argument is heavily skewed in favor of value, with high growth attempting to gain a foothold in the battle for market share.
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