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Are value stocks good investments or should you invest in growth?

According to data from wealth manager Brewin Dolphin, value funds have significantly underperformed growth funds since 1995. Hearing something like that might make an investor wonder if value stocks are good investments. Should they perhaps switch to growth investing?

Do value investors always buy value stocks?

When investors think of a value stock, something like a large consumer company that pays a stable dividend might come to mind. When asked to think of a growth stock, an upstart FinTech company rapidly increasing its revenues might fit the bill. But not all FinTech companies are growing, and not all consumer companies are cheap investments.

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In the investing game, the price-to-earnings ratio (P/E) defines growth and value. A growth stock has a P/E ratio higher than the market average, while a value stock’s P/E ratio is lower. For reference, the trailing 12-month P/E ratios of the FTSE 100 and FTSE 250 were about 18.7 and 19.5 respectively, measured over the last five or so years. Some investors might choose a P/E of 12 as a benchmark for distinguishing between growth and value stocks.

So, we have a straightforward way of identifying a value stock. But value investing does not necessarily involve buying only value stocks. An investor can go further and ask if a stock is undervalued or overvalued. First, find the average P/E ratios of all companies that operate in the same sector and industry. Then the target company’s P/E ratio can be compared to the average. If it is lower, then the stock is relatively undervalued, and if it’s higher, the stock is relatively overvalued. The average P/E for an industry or sector is also a useful metric, but more about that later.

Both undervalued growth stocks and undervalued value stocks might be in the remit of value investors. Still, they might avoid an overvalued stock, even if it has a lower than average P/E ratio.

Hostile environment

Interest rates have been declining since the early 1980s, but have flatlined near zero since 2009. The bulk of a fast-growing company’s cash flows are far in the future, beyond the economic stresses of today. Discounting them back at lower interest rates increases the value today.

A slow-growing mature company has already accrued the bulk of its cash flows. Lower interest rates don’t offer much help here. But short-term economic shocks hurt because investors will worry about collecting next year’s dividend.

Compounding the issue

So should a value investor give up and switch to growth? Not necessarily. First, some value funds payout income rather than reinvesting it, which will lower their growth rate, possibly skewing the data. Secondly, the economic environment, particularly since 2009, has been supportive of growth, and detrimental to value, which may change.

Finally, are value funds and investors investing in value? Picking stocks based on them having a low P/E ratio alone is not value investing. Undervalued value stocks could be good investments, but beware of value traps. An entire industry might have a low P/E ratio because it’s on its last legs (think of video rentals in the late-2000s); an undervalued value stock in such an industry is not a good buy. And remember value investors can also look at undervalued stocks in a growing industry 

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James J. McCombie owns shares in Brewin Dolphin. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.