How do growth, value & quality investment styles differ?
Growth, value and quality are three of the most common investment styles to consider when when buying shares in different companies and constructing and managing risk within an investment portfolio. Companies that represent a particular style will share similar characteristics, which can be measured using financial metrics. Each style can perform differently depending on market conditions and structural trends. By understanding investment styles, investors can assess the underlying risk-reward profiles of individual companies and improve their overall portfolio diversification.
Growth investing
Growth investors seek companies that offer strong growth potential in their earnings or market share, often through technological disruption or innovative new products, which can lead to significant outperformance over the short and long term. These companies’ share prices can be volatile – both on the way up and, sometimes, on the way down – as they are highly sensitive to investors’ expectations and market conditions.As an investment style, growth tends to outperform when interest rates are low or falling because these companies often require funding to finance their expansion. Moreover, their valuations are heavily reliant on future earnings, which mathematically become more valuable as interest rates decline. Nevertheless, their success or failure is ultimately determined by whether they can deliver on their strategy and products.
“Managing a portfolio’s exposure to different investment styles can increase diversification and potentially improve performance in certain market conditions.”
Ben Ritchie, Head of Developed MarketS Equities, abrdn
Value investing
Value stocks are usually mature companies that investors consider cheap according to financial metrics, such as those that compare the company’s share price to its earnings or asset book value. They may exist in industries experiencing slow growth, or investors may simply lack confidence in an individual company’s prospects.
This presents opportunities for investors to find ‘diamonds in the rough’ by identifying companies that can turn their fortunes around. From a macro perspective, these companies can also benefit from higher economic growth and, in some sectors, higher inflation or interest rates. Value stocks that generate enough cash may also pay above average dividends to make shareholders’ total returns more attractive.
Value investors must determine which stocks have the genuine potential to recover and avoid ‘value traps’, which are companies that will continue to decline.
Quality investing
Quality companies typically have pricing power, strong balance sheets, durable competitive advantages and less cyclical earnings, which makes them better placed to deliver against expectations than the broader market. They also have the potential to perform in a wide range of market conditions. Their share prices are not cheap, but investors believe they represent a case of ‘you get what you pay for’.Relevant financial metrics for quality companies include return on capital employed, which measures how efficiently a company is using its capital to generate profits, and the debt-to-equity ratio, which shows how capital has been raised to run the business and provides a guide to its financial stability.
How do investment styles affect portfolio performance & diversification?
Total return comparison between the standard, global stock market index (MSCI ACWI) and its variant indices comprising growth, value and quality companies respectively.
Past performance is not a guide to future performance.
Over the long term, quality companies have demonstrably outperformed (see chart above). This intuitively makes sense as these companies should be better positioned to consistently deliver strong earnings and take advantage of their market share or dominance. As time goes by, these benefits compound leading to a continually widening performance gap through market cycles. This creates a strong argument for a quality investment style bias for long-term investors.
Nevertheless, tactical allocations to growth and value can result in additional outperformance. In terms of individual stocks, this means correctly identifying future market leaders or undervalued companies, respectively.
From a portfolio diversification perspective, it involves understanding the direction of the market cycle and adjusting portfolio exposure accordingly. For instance, if an investor expected interest rates or inflation to stay higher for longer, a larger allocation to certain value stocks would make sense.
Conversely, if the market’s risk appetite increased, perhaps fuelled by economic growth or lower interest rates, it is likely that growth stocks would collectively benefit.