The fallacy of the growth vs. value debate

The investment world loves to pit value investing vs. growth investing. Good investors know that both should play a role in your portfolio.

By John Reese Aug 19, 2011 4:24PM

Coke or Pepsi? Magic or Larry? The Beatles or the Stones? Life is full of such "either/or" questions. The investing world is no different, with perhaps the greatest being "growth, or value?" And, like most of those other debates, the growth or value question is misleading by its very nature, presupposing that you must embrace only one or the other -- not both.

 

For investors, such thinking can cost you a lot of money. That's because, as I've found after more than a decade of studying history's most successful investment strategies, the best approaches usually use a combination of value and growth criteria. As Warren Buffett has said, "growth is simply a component -- usually a plus, sometimes a minus -- in the value equation."

 

Of course, certain strategies will focus more on growth criteria, and others focus more on valuation criteria. But even so, there's no reason an investor should restrict themselves to one or the other. Look, for example, at James O'Shaughnessy, whose book What Works on Wall Street forms the basis for one of my best performing "Guru Strategies" (each of which is based on the approach of a different investing great). O'Shaughnessy back-tested a myriad of investment approaches, eventually landing on one growth-focused approach and one value-focused approach. Both strategies handily beat the broader market over time, but he found that he could build an even better portfolio (as judged by risk-adjusted returns) by using some stocks picked with the value model and some picked by the growth model.

 

I've had similar results. Since its inception more than eight years ago, a portfolio picked using both my O'Shaughnessy-inspired growth and value models has returned 9.0% annualized, in a period in which the S&P 500 has averaged just 1.6% per year. And, it's actually done that with a slightly lower beta -- 0.99 -- than the S&P.

 

This year, the strategy has been particularly successful, with the portfolio returning 4.3% while the S&P is down 9.3%.

 

One reason I like this approach so much is the flexibility it offers. Growth-focused strategies and value-focused strategies can each go out of favor for periods of time, so this combination strategy doesn't tie you to one or the other. Right now, for example, the portfolio is finding a good deal more values among growth-oriented stocks, with 8 of its 10 holdings chosen with the growth-focused model. But if market conditions change -- and given all the recent turmoil, that's certainly a possibility -- it could shift back toward value stocks.

 

So, how do my O'Shaughnessy-based growth and value models work? Here's a quick breakdown:

 

Growth: The growth approach looks for firms with market caps of at least $150 million that have grown earnings per share in each year of the past half-decade. While it's a growth-focused strategy, it also uses a key valuation metric: the price/sales ratio, which should be under 1.5. The strategy takes all of the stocks that pass those first three criteria and ranks them according to relative strength (my model uses RS over the past 12 months), giving final approval to the top 50. The combination of a high RS and low P/S ratio was key for O'Shaughnessy -- he found it turns you on to stocks that are being embraced by the market, but which haven't gotten too pricey.

 

Value: The value method looks for larger stocks using three criteria: market cap should be at least $1 billion, trailing 12-month sales should be at least 1.5 times the market mean, and number of shares outstanding should be greater than the market average. But size alone isn't enough. The firm should also have a cash flow per share greater than the market mean. The strategy then takes all the stocks that pass those first four tests and ranks them by dividend yield, with the top 50 getting final approval.

 

Now, let's look at a trio of top O'Shaughnessy-inspired growth plays, and a pair of O'Shaughnessy-type value picks.

 

America's Car-Mart, Inc. (CRMT): Headquartered in Bentonville, Ark. (just a few miles down the road from the corporate offices of a much bigger "Mart" -- Wal-Mart),  America's Car-Mart operates 107 auto dealerships in the southern and midwestern U.S. It's the country's largest publicly held dealer that focuses solely on the "Buy Here/Pay Here" model (i.e., it provides financing for just about all of its sales).

 

Car-Mart ($320 million market cap) gets approval from my O'Shaughnessy-based growth model. A few reasons: It has upped earnings in each year of the past half-decade, growing EPS from $0.35 to $2.54 over that time; it trades for just 0.84 times sales; and it has a relative strength of 86.

 

Ross Stores Inc. (ROST): Based in Pleasanton, Calif., Ross is the second-largest off-price retailer in the U.S., operating more than 1,000 stores under its Ross Dress for Less and dd's Discounts names. It sells clothes, accessories, shoes, and a variety of home goods, and in the past year has taken in more than $8 billion in sales.

 

Ross ($8.3 billion market cap) upped EPS throughout the recession -- in fact, 2004 is the only year in the past decade when it didn't increase EPS. It's also selling for 1.01 times sales, and has a relative strength of 87, making it another favorite of the O'Shaughnessy-inspired growth approach.

 

Cash America International Inc. (CSH): Cash America operates in more than 1,000 locations in the U.S. and Mexico, providing secured non-recourse loans -- pawn loans. It also offers short-term cash advances and check cashing services. The Fort Worth, Tex.-based firm has a market cap of about $1.5 billion.

 

You might not expect "consistent" to be a word associated with a pawn loan company. But Cash America has upped EPS for eight straight years, one reason my O'Shaughnessy-based growth model likes it. A couple others: The stock has a red-hot 92 relative strength, but hasn't gotten too pricey, selling for 1.11 times sales.

 

AstraZeneca PLC (AZN): London-based AstraZeneca is one of the world's largest drugmakers. The $61-billion-market-cap firm is active in more than 100 countries, and makes a variety of well-known medications, including Crestor, Symbicort, and Nexium.

 

AstraZeneca is a favorite of my O'Shaughnessy-based value model. It certainly has the size -- in addition to that huge market cap, the firm has almost $33 billion in trailing 12-month sales (vs. the market mean of about $19 billion), and more than twice as many shares outstanding (1.4 billion) as the market average (615 million). It's also generating more than six times as much cash ($8.16 cash flow per share) as the market mean ($1.30). And, to top it off, AstraZeneca shares are offering a 6.0% dividend yield.

 

Petroleo Brasileiro SA (PBR): One of the largest integrated oil and gas companies in the world, "Petrobras" is based in Brazil and has a presence in 28 countries. The $176-billion-market-cap firm, which announced strong second-quarter profit numbers this week, has taken in more than $125 billion in sales in the past year.

 

That size is one reason my O'Shaughnessy-based value model likes Petrobras. Two more: The firm is generating $4.80 in cash flow per share, nearly four times the market mean, and its shares come with a 4.5% dividend yield.

 

I'm long ROST, CSH, AZN, and PBR.

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