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I frequently get emails and tweets from investors looking for the next growth stock. I have to politely excuse myself from this conversation. Growth investing is not my forte and in a way, very few ever do growth investing with any reasonable levels of success. This of course, is for no lack of trying.

Growth Funds Lead Value Funds in Total Assets

According to the latest mutual fund asset flow report by Morningstar, investors continue to invest more in growth funds compared to value funds in all asset classes.

Total Net Assets ($billion)GrowthValueGrowth %
Large Cap1,13178359%
Mid Cap26913766%
Small Cap1809965%
OVERALL1,5801,01961%

As of Nov 30, 2013

Note: Total assets under management directed toward US equity is $4.5 trillion. Of this, Growth commands $1.58 trillion and Value commands $1.02 trillion. The remaining $1.9 trillion is a mish mash in style agnostic index funds, blend funds, sector funds, etc. and I'm making a leap of faith in assuming that the growth/value distribution among these roughly corresponds to the table above.

This is after $17.5 billion flowed out of the growth funds in the first 11 months of 2013 and $40.9 billion flowed into value funds during this time. There was a sustained flight out of growth funds in 2013 and into value funds and it is arguably one of these times when value is in favor so a "normal" growth/value distribution is more skewed toward growth.

Perhaps the value universe is just smaller and can't bear additional investor capital. Value, by definition, is out of favor companies, so it stands to reason that there is less investor money in value stocks. I can accept this. However, the point remains - An average investor tends to be MORE exposed to growth stocks than value stocks if he invests through typical investment vehicles in his taxable and tax deferred accounts.

Why Should Investors Care?

I have earlier presented historical performance data that shows value stocks outperform growth stocks in all asset classes when considered on a long-time horizon. While the average outperformance is 2.2% per year, it is more pronounced in smaller capitalization stocks and the performance gap is over 8% annually for micro caps. In all cases, growth stocks underperform the average market and value stocks outperform the average market.

Based on the historical trends and the AUM data above, an average investor has as much as 60% of his portfolio pre-disposed to underperforming the market. It is probably worse as most portfolios are more large-cap biased than the averages, as small-cap investors tend to be more exclusive to the asset class. Small cap funds are also less accessible as they close sooner and have more expensive fees. Besides, the media loves to stress the relative safety of larger capitalization stocks (I personally consider getting less returns over time as more risky investment - not less risky), because these names tend to be better known and appeal more to their audience.

So Why Do Value Stocks Outperform Growth Stocks?

To understand this, we first have to figure out what really is a growth stock. Forget all the ratios and intrinsic values and margin of safety and EPS growth estimates and all other stuff we love to use to find out investments, for the moment. Sometimes the simplest thing is to go back to the basics. There are precisely three kinds of growth stocks:

  1. A young company, an IPO: Start up companies that have achieved a certain level of business success, not necessarily profitability, may at some point decide to offer shares held by insiders to the public in an initial public offering. The business models may be proven at this point to have some staying power and tremendous growth may be expected.
  2. An old company that fixed its problems and regained growth: Every business goes through lean patches. Sometimes this is competition induced, other times there may be operational mistakes, or in some cases the external environment may have shifted. A good company with competent management will adapt to these changes in time but there will be periods of low growth or decline accompanied by falling stock prices until the management actions start to bear fruit.
  3. A small biotech or drug company: Generally these companies should be considered as a portfolio of projects. Some projects pan out, others do not. As long as the portfolio is small, each individual project has significant impact on the value creation (or destruction) process for shareholders. The reason I treat these companies different than others is that these firms are too dependent on externalities. Even if the operations, strategy and management are sound, the success or lack thereof of the business rests in the hands of the government regulatory agencies and this is too much of a risk to bear and impossible to plan for.

IPOs are generally terrible investments, even if they may come with significant growth potential. Whatever value exists in the growth prospects is more than obliterated by the mechanics of the IPO. Think of the IPO as a legalized insider selling, except it is even worse. The management and the runners of the IPO have every incentive to maximize the share price while the investors are hampered with the asymmetrical knowledge of the business fundamentals. Similarly, a lot of potential growth in a small biotech or drug company is not dependable (large biotech or drug firms do not have this issue as they have predictable revenue streams from drugs already in the market and new products are a smaller part of their business).

Value investors tend to scout for companies that are in temporary difficulty and the stock has been out of favor. We prefer to get in these stocks when they are cheaper and so eventually when the business improves and growth returns, we realize the capital appreciation we are looking for. The advantage of getting in earlier are manifold:

- Paying cheaper prices means greater capital appreciation

- Since the future growth is always risky and can be derailed by any number of factors, buying at the point of maximum pessimism is actually less risky as the potential capital loss risk is minimized. It is a given that appropriate due diligence is necessary, not all bargain stocks are great values.

Generally in my practice I have found that I tend to sell when the growth story becomes real and growth investors start to come on board. This may leave some further capital appreciation on the table, but it is more than made up by getting a better purchase price and avoiding the risks that come with growth investing.

Note: These are just one type of stocks value investors look for. There may be other situations where a stock may be deemed undervalued and some of these may be independent of the future growth prospects of the company.

Source: Why Do Value Stocks Outperform Growth Stocks?