“Warren and the Terrible, Horrible, No Good, Very Bad Year.” That’s how Money Magazine characterized Warren Buffet’s performance this year. After all, his top picks have taken a beating year to date: Procter & Gamble is off -14.18%; IBM is down -13.67%; and Walmart stock has plummeted by nearly one-third, off -30.84%. (Source: Yahoo Finance as of 12/9/15).
When one of the most well respected investors of all time has a “bad year,” it’s big news. But does that mean he’s lost his Midas touch? No. Berkshire Hathaway’s performance this year is a function of Buffett’s investment philosophy: value investing.
THE DIFFERENCE BETWEEN VALUE AND GROWTH INVESTING
While there are as many ways to classify stocks as there are pundits crunching data, value stocks typically, have a lower price-to-earnings (P/E) ratio, which means that the stock currently has a lower price per share relative to the company’s earnings per share. Growth stocks are just the opposite. Typically, they have higher P/E ratios; investors who buy growth stocks are willing to pay more per share because they believe the stock price will go even higher. Think of value investing as buying a cheaper home that needs repair instead of paying more for the most expensive house in the neighborhood.
VALUE INVESTING IS A LONG-TERM STRATEGY
Value investors are bargain hunters. They seek out stocks that they believe are cheap, undervalued, or unappreciated by the market; they look to invest in companies that are suffering in the short term, but are capable of a comeback. Buffett advises, “Buy into a company because you want to own it, not because you want the stock to go up.” When Warren Buffett invests, he looks for high quality, undervalued companies capable of generating earnings and making money eventually, if not right away. He “buys low” and waits patiently, with little concern over short-term performance. Says Buffett, “In the short term the market is a popularity contest; in the long term it is a weighing machine.”
So Value stocks are priced more attractively, but the ultimate question remains: Do Value stocks outperform Growth stocks? The answer depends on whether you mean now or over the long term.
UNDERVALUED FIRMS ARE CURRENTLY OUT OF FAVOR
Over the last 12 months, Value stocks have barely budged. Their sluggishness can be attributed to the meltdown in energy prices, the correction of dividend stocks, slow economic growth in a low interest rate environment and other factors. During that time, investors have rewarded Growth stocks that have the ability to grow their businesses even in a scarce economic growth environment.
LAST 12 MONTHS: VALUE STOCKS HAVE STAYED PUT
(Data source for all graphs from Morningstar as of 11/30/2015 using the Russell 3000 Value TR USD and the Russell 3000 Growth TR USD indexes.)
WITH TIME, THE GAP NARROWS
Over time, out-of-favor value companies can demonstrate their earning potential, which then closes the performance gap between Value and Growth stocks. For example, even over the last five years (still considered short-term), Value stocks returned 13.23%, just 1.73% shy of Growth stocks’ 14.96% performance:
OVER 5 YEARS, VALUE NARROWS THE GAP
LONG TERM: VALUE PAYS OFF
Over the long term, cheaper Value stocks generally outperform pricier Growth stocks, but to earn that performance pay-off, Value investors must be patient. When we compare performance over the last 15 years, Value has outperformed Growth by a substantial margin – despite Growth’s recent rout over Value:
OVER 15 YEARS, THE VALUE STRATEGY WINS
So do we think Warren Buffett is worried about this year’s performance? No.
Do we think the Oracle of Omaha has lost his touch? No, because long-term investing favors cheaper Value stocks over pricier Growth stocks.
So how consistent is this value-beats-growth strategy? Here’s the data:
GROWTH STOCKS VS. VALUE STOCKS (1945-PRESENT)
Value rebounded after periods in which Growth prevailed
This chart plots the trailing five-year annualized return of a hypothetical Value vs. Growth portfolio that goes up when value stocks are outperforming growth stocks and down when growth is outperforming value.1
Although our brains tend to extrapolate current patterns as predicative of future results, the data does not bear that out. Growth’s current dominance over Value is not the norm and history suggests the trend will revert – but no one can predict the future. Since 1945, there have been six multi-year spans where Growth beat Value (the last time Growth stocks dominated was during the dot-com bubble). Yet as the chart shows, after each of the last 5 periods where Growth dominated, Value stocks made a significant comeback over the next five years. We are currently in the sixth period where Growth is outperforming Value. Of course, past performance does not predict future returns.
When investors are extremely “greedy” – for example, during the dot-com stock bubble − they tend to chase the performance of popular Growth stocks, often disregarding (and driving up) price, thus inflating Growth stock prices further.
When investors are overly “fearful” (as we’ve seen in recent years), they again seek comfort in popular stocks (typically fast-growing companies whose price is increasing) because they feel safer, regardless of how pricey they might be. That buying behavior can inflate prices even further.
Once investor emotions return to normal, cheaper Value stocks typically do better than their pricier Growth counterparts, since buying low creates greater opportunity for capital appreciation. An important truth about investing: The difference in investment performance mostly has to do with the price you pay.
Throughout his long career, Buffett has consistently touted the value of buying on the cheap: “Price is what you pay; value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” “Buy low, sell high” – the familiar lingo for value investing – is Warren’s mantra and one of GV’s core investing strategies, too. While we can’t predict when Value stocks will rebound, we believe in reversion to the mean and the historical data supporting our Value bias.
1 All performance information is hypothetical and does not reflect the actual performance of an investment fund. Past performance is no guarantee of future results. The data used in this study is publicly available, believed to be reliable, and can be accessed here. Original chart courtesy of Euclidean Technologies. More analysis is available at Advisor Perspectives.