In a great book "Hedge Hogging", the author, Barton Biggs, writes about the dangers of switching investment styles.
“Agonistics don’t believe in either religion. They say that everything in the investment business is temporary. “This too shall pass” is their mantra. Religious fanatics, they argue, often end up getting burned at the proverbial stake. When growth stocks are relatively cheap and the economic environment favors them, agnostics will own growth. When value is cheap and growth is expensive, they will look for value. Sometimes they will own a little a both. They maintain that there are fashion swings between growth and value that the intelligent investor can capitalize on. The hard-core growth and value investors reply that switching back and forth is a loser’s game. I am an agnostic, but because buying cheap beats buying expensive most of the time, I have a strong value bias.
GROWTH OR VALUE: WHICH PERFORMS BETTER?
The performance history of growth versus value is clear. Over a period of years, value beats the daylights out of growth, and small-cap value is by far the best of all. Authorities like Ibbotson and Fama-French have constructed indexes of growth and value and have calculated their performance. Since 1927, according to Ibbotson, large value stocks have compounded at 11.5% a year and small value has compounded at 14.8%. By contrast, big growth has gained 9.2% per annum and small growth 9.6%. Because of the magic of compounding over 75 years, these are staggering differences. One dollar invested in each index in 1927 would be worth today $35,957 if you had put it into small value, $4,802 into large value, $1,089 in small growth, and $820 in large growth! The difference between small-cap value and everything else is astounding. Small value did almost eight times better than large value and more than 40 times large growth. Ben Graham must be smiling. Only in the 1930s and the 1990s has large growth beaten large value for a full decade. Small growth has trailed small value in every decade except the 1930s. However, in any given year the disparity can be incredible. For example in 1998 large growth stocks returned 33.1%, while large value did a mere 12.1%.
If you have to pick only one vehicle, small-cap value is where individual retirement accounts (IRAs) and long-term index money should be in the United States. It’s obvious. Equities are a high-return class, and small cap is the best of breed. Unfortunately, right at this moment, small cap, both growth and value, are historically expensive relative to big cap. Over the last six years, small caps have done much better than large caps and small cap value has soundly trounced small-cap growth. I would be patient and wait to buy either small-cap index. Instead, right now in mid-2005, large caps are relatively attractive compared to small caps, and large-cap growth is relatively undervalued compared to large-cap value. The Leuthold large-cap growth index of 90 companies is selling at 20.5 times earnings and the Leuthold value index is at 11.9 times, which is a growth to value price earnings ratio of 1.68 versus the history median of 2.5.
For IRAs the Vanguard index funds make sense to me. Sure, you can capture alpha, extra return, if you identify a winner mutual fund, but you are bucking a number of headwinds in terms of higher costs, performance cycles, manager turnover, and so on. When the time comes and small value is cheap again, Vanguard has a Small-Cap Value Index Fund. The stock selection is based on the MSCI Index, which, in making its selection, uses eight value and growth factors, including price/book value, dividend yield, earnings yield, sales growth, and long-term-earnings growth. MSCI defines U.S. small cap as those equities ranked from 751 to 2,500 in market capitalization. Based on each stock’s score, the computer then places it in the MSCI value or growth index. Not an ideal way to do it, in my view, but nevertheless it captures the essence of the exercise. Equally important, management expenses for the fund are minuscule. There is no sales load whatsoever, and total annual expenses are 27 or 18 basis points, depending on the class of shares owned. Comparable actively managed funds would have expenses of 80 to 150 basis points not including sales charges.
Growth managers argue that the Vanguard and Ibbotson indexes are ridiculously simplistic, and they say their special skill is in identifying companies that are capable of sustained growth and avoiding the losers. They maintain that their portfolios are populated with vision stocks. Arbitrary quantitative groupings, they say, prove nothing. These growth managers sometimes maintain, a little arrogantly, that they have the true seeing eye for beauty, and disdain the value geeks who grub in the muck, searching for cheap ugliness. The real test, they argue, is the results of the portfolios of professional growth stock investors versus those of value investors. They also maintain that, for tax-paying investors, the turnover and tax bill in value portfolios is much higher because, in accordance with their religion, value investors have to sell their winners when they go up. By contrast, growth investors can live happily in their eternally growing money trees for decades.
Here is an example of how it can work if your stock selection is fortunate. In the early 1970s, my father was worried about his health and inflation and suspected my mother would outlive him by a considerable number of years. He never was much of a believer in bonds. “Bonds are trading sardines, but good stocks are eating sardines,” was an expression he favored. So he constructed for my mother a portfolio of growth stocks (and cyclical growth stocks) such as Phillip Morris, Caterpillar, Exxon, Coca-Cola, AIG, IBM, Citicorp, Hewlett-Packard, Berkshire Hathaway, GE, Merck, Pfizer, and so on—nothing very imaginative, but solid, long-term companies you would want to sleep with. When she died two years ago at age 95, her cost on many of those positions was actually less than the current dividend.
My mother’s portfolio compounded over 32 years at 17% a year, and her dividend income grew at about the same rate. I figure the purchasing power of her income stream had compounded at roughly 12% per annum. The only taxes she paid were on those dividends. Talk about tax-free compounding! Of course, as she grew very old, it made little sense for her to sell any of those shares. No matter how egregiously overpriced they became, she held on to them because she would have had to pay a whopping capital gains tax and then her heirs would have to pay a 55% inheritance tax on the proceeds. Of course, the trick is to find and hold growth stocks that can stand that test of time, and obviously it’s difficult. My brother Jeremy and I watched her list intently, and from time to time, we did weed out and replace a few companies that we thought were beginning to falter.
My brother and I were lucky, and we had the wind at our backs. I think it’s too dangerous for the amateur to pick individual stocks. As I mentioned earlier, history shows that the lifespan of growth stocks is short, and the fall from grace when it comes can wipe out years of gains. As for mutual funds, their managers come and go, and the fees are high. If you can find someone like, Bill Miller at Legg Mason, it’s a gift from heaven. As I noted before, an attractive alternative is owning an index fund, and they come in all shapes and sizes with minuscule fees. At least you are going to capture the index return. The two biggest index fund firms by far are Vanguard and Fidelity.
Growth investing, because of its bias toward a buy-and-hold strategy, is inherently more tax efficient. However, for tax-exempt investors, the hard evidence is that the actual portfolios of value managers beat those of growth managers.. It is also interesting to note that, during one of the great speculative growth stock bubbles of all time, only in 1998 and 1999 did growth absolutely bury value.”