Beginners Guide to Buying Share in the UK: Growth or Value?

One of the first decisions a beginner investor has to make is how to balance capital allocation between ‘growth’ and ‘value’ companies. The decision even has to be made if the investor has taken the decision to opt for funds rather than trying to pick winners themselves, which is often the best decision for those who lack experience or time. Funds might be passive index trackers but if they are actively managed the manager will either have a growth or value strategy, or some blend of the two. The investor must still make a call on which funds to opt for.

So what is the difference between equities defined as ‘growth’ and those considered ‘value’ and what are their relative strengths and risks?

Growth shares belong to companies that have a recent history, and the future prospect of, strong growth in metrics considered important to long term returns. This will generally be growth in revenues, users, market share or, ideally, a combination of all three. The share price of growth companies is much more expensive than stock market averages based on revenue multiples. For example, Amazon shares trade at a multiple of over 210 times the company’s earnings. The average earnings multiple of companies listed on major US stock exchanges is times 25. Belief that Amazon will continue to grow quickly means investors are willing to pay a huge premium for its shares in comparison to other companies.

Tech stocks usually fall into the ‘growth’ category but the category is not limited to the tech sector. Any company trading at a much higher than average multiple of earnings because investors are confident about its future earnings potential would be considered a ‘growth’ company.

Value shares are the opposite end of the spectrum and trade at a multiple of revenues lower than the wider market average. Companies can lose the favour of markets for all manner of reasons but the most common are a rough patch when income or market share temporarily drops, management problems, scandal or a combination of several factors. Share value often lags these problems having been resolved. Value investors specifically look for healthy companies markets are temporarily undervaluing and look to buy their shares before their value returns to what the company’s fundamentals suggest it should be.

Which is the Better Investment - Growth or Value?

While both categories of shares have their disciples and investors that swear by a strategy of focusing investment on one or the other, the truth is that both categories have historically seen periods of dominance in terms of which delivers the better returns. Since 2010 growth stocks have outperformed value stocks by over 20%. However, over the 22 years between 1987 and 2009, focusing on value stocks would have been the better approach. During that period growth stocks outperformed value options only between 1998 and 2000 as the dotcom bubble melted up.

As a rule of thumb, growth stocks do better during a strong bull market and value stocks under more ‘normal’ conditions or a downward trending market. Growth stocks are a bet on future returns which can never be guaranteed. As Sam Vecht, manager of the Black Rock Frontier Markets investment trust put it in The Times:

“There is evidence to show that ignoring the cost of what you pay for an investment in the hope of receiving a higher price eventually is not a good strategy. It’s all about the price.”

A look at some figures that up. Shares in company with a value reflecting an earnings multiple of zero to seven bought ten years ago would have, on average, returned 11% a year since. A share price reflecting a 7 to 14 multiple of revenues would have delivered a still healthy 6%. If price was close to the stock market average for revenue multiple, at 21 to 28 times earnings, average returns would have been a meagre 1%.

However, that logic no longer holds when we get into growth company territory. The likes of Amazon, Apple and Facebook trade at values in the multiples of hundreds of times revenue but delivered the strongest returns of all. Ignoring these growth companies would have meant missing out. The problem is that achieving strong returns from growth companies requires good market timing – getting in and out at roughly the right moment. That’s tricky even for experienced investors.

There is no right or wrong answer to the balance of capital that should be allocated to value and growth shares. However, if a bull market run appears to still have plenty of time to run a greater allocation can be made to growth shares and when the end looks like it might be near, retreat to value. That approach should be considered very approximate. If, as an investor, you’ve secured strong returns from growth shares and then sold but the bull market has continued for another year or two, don’t worry about the growth missed out on but be content with what you have secured. You’ll never be able to time the market perfectly and trying to do so will ultimately significantly increase the risk of being caught by a major correction at the end of a bull run.