It’s a matter of style: Understanding growth and value investing

Part 1: Value and growth investing – what’s the difference?

As you might expect, growth investing is an investment style where you seek companies whose sales or earnings are expected to grow at a higher rate than the average company. For example, a company involved in the production of drones could offer attractive growth stocks because drones are really popular and offer a lot of expected future growth. Typically, investors are willing to pay more today for a stock like this to have the opportunity for future growth. These companies generally don’t pay dividends, as they reinvest earnings to grow their businesses.

Another characteristic of growth companies is they tend to have high price-to-earnings (P/E) ratios. This refers to the price of the company’s stock divided by their earnings.  Investors in a growth company are forecasting that the growth will accelerate and are willing to pay more today for those future cash flows, hence the higher P/E ratio.

On the opposite end of the spectrum is value investing, whereby investors seek companies whose stock price appears cheap or undervalued relative to what they think it should be (fair value). This situation could occur, for example, while a particular industry is struggling and the market punishes all stocks in that industry equally, failing to take into account a company’s individual circumstances. If they offer better prospects than their peers, certain stocks in the industry may represent good value at their current prices.

While growth companies have higher P/E ratios, value companies tend to have lower P/E ratios. This is as a result of investors discounting the potential earnings growth that they expect from the company due to market sentiment or under-valuation.

Ultimately why does classifying stocks into value and growth matter? There is a plethora of academic research that suggests value stocks outperform the broad market in the long run. However, not all stocks fit nicely into either a value or growth bucket.  Therefore, it is important to have a robust portfolio construction process to build a diversified exposure to value.

Part 2: Practical ways to focus on value investing

To take advantage of opportunities, the challenge is to identify value companies that have been mispriced relative to their fair value to extract the ‘value premium’.

As a result of Russell Investments’ extensive research on value investing, we have designed the Russell High Value Australian Shares ETF (RVL).  This ETF aims to deliver a high conviction, high tracking error portfolio with a specific bias to value. We use a quantitative model to identify approximately 40-60 value stocks in the Australian market. Stocks which have strong value characteristics are overweighted, whereas those with more growth attributes are penalised and are either underweighted, or not held at all.  The end result is an ETF that delivers an easy-to-access exposure to Australian value stocks.

As an investor or adviser, it’s likely you have the majority of your money invested in managed diversified (or multi-asset) funds. But if you want to take a high conviction bet on value, you can put RVL in the mix. Priced at 0.34%, RVL has lower fees compared to typical pricing for most managed funds. From a portfolio construction point of view, you gain exposure to the value premium, but at a lower cost.

Keep in mind that RVL is not a substitute for a globally diversified portfolio with a mix of shares, bonds and other asset classes. But it does offer a way to access more targeted exposures to Australian value shares at an affordable price.

If you are a direct stock investor, RVL could be a simple and transparent way to access a portfolio of Australian stocks with a value bias. Especially at times when the market declines, it is often the value stocks that are “picked on” in the news. At those times, having an allocation to RVL alongside your stock portfolio can help you maintain a disciplined approach to value investing. It can help you avoid the common human impulse to sell when prices are at a low (instead of ‘buying low’ and ‘selling high’).

However, with any style of investing, keep in mind that a balanced approach is critical, as no one has a crystal ball to tell whether value or growth styles will be in favour in the near term. There can be stretches of time when different styles have markedly different performance. It is said that value works terrifically in the long run, but often fails miserably in the short term. It comes down to how much patience you have through market cycles – and having a diversified portfolio with a mix of different styles can help you weather different environments.

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