Value Vs. Growth Trading Strategy: Evaluating the Best Approach through Backtesting and Performance Analysis

Investors have a variety of options when it comes to investing strategies — Bond vs. Equity, Passive vs. Active, and Value vs. Growth strategy. Here, we focus on the two most popular strategies — Growth Investing and Value Investing. The two methods differ in many ways. Let’s find out: what is best – value or growth? We backtest both growth and value stocks and also make a value and growth rotation strategy that are switching between the two strategies .

Value vs. Growth trading strategy is one of the most popular comparisons in the investing world. Value strategy prioritizes buying undervalued stocks with strong fundamentals, with the expectation that the market will eventually recognize their value. Growth strategy, on the other hand, focuses on buying stocks of companies that have strong potential for future growth, regardless of their current valuation.

In this post, we take a look at Value vs. Growth trading strategy. We make several backtests to find out what is best, growth or value stocks.

We further show you a value and growth rotation strategy and system that beats buy and hold.

Exploring the Trade-Offs of Value and Growth Investing

Let’s get started:

Value investing and growth investing are two popular investment strategies that investors have used for decades. Both strategies have their own set of advantages and disadvantages. Understanding these trade-offs can help investors decide which approach may be best for their circumstances and whether they can combine the two.

What are value stocks?

Value investing is an investment strategy that involves buying undervalued stocks with strong fundamentals, expecting the market to eventually recognize their value. Value investing aims to buy low and sell high, and it is often associated with long-term investments. Value investors tend to focus on companies that are currently undervalued by the market, but have strong fundamentals and a proven track record of success. This approach can be beneficial for investors who are looking for stability and current income, as well as long-term appreciation.

What are growth stocks?

Growth investing, on the other hand, involves buying stocks of companies that have strong potential for future growth, regardless of their current valuation. Growth investing aims to capitalize on the potential for appreciation, which is often associated with short-term investments. Growth investors tend to focus on companies that are experiencing rapid growth, such as technology companies and startups. This approach can be beneficial for investors who are looking for high returns in a short period of time, but it also comes with a higher level of risk.

Backtesting strategies to identify the optimal mix of value and growth

Backtesting involves applying a trading strategy to historical data to assess its performance. Backtesting allows investors to test their strategies in a simulated environment and make adjustments based on the results. It can be used to identify the optimal mix of value and growth investing strategies.

We recommend reading our own backtesting guide.

To backtest value and growth investing strategies, you first need to define their investment universe — the group of securities you will be testing. You also need to define your trading criteria, such as the specific metrics and rules you will use to identify value and growth stocks.

Next, you have to source the backtesting software and historical data to use for your backtesting. You can get it from TradingView or Yahoo Finance or subscribe to MultiCharts. With the data and backtesting software in place, you start the backtesting by applying your strategy criteria to the historical data and then analyze the results. This will provide insight into how the strategy would have performed in the past and can help identify any issues or areas for improvement.

By testing different combinations of value and growth stocks, you can determine which mix of value and growth stocks has the best return potential while minimizing risk. For example, you may find that a portfolio heavily weighted toward value stocks may provide stability and current income, but may not offer the same level of appreciation as a portfolio heavily weighted toward growth stocks.

Deciding between value and growth investing: A comparison

Both value and growth investing strategies have their own set of advantages and disadvantages (pros and cons), which you need to consider before deciding which approach may be best for you. Generally, value investing can provide stability and current income but may not offer the same level of appreciation as growth investing.

In terms of returns, value stocks tend to have lower volatility and may provide relatively consistent returns over time.

Growth stocks, on the other hand, have a higher potential for appreciation but also have a higher potential for volatility. Value stocks tend to pay dividends, which can provide a steady stream of income, while growth stocks may reinvest earnings back into the company instead of paying dividends. That said, be careful in labeling dividends as income. We like to call it earnings distributions, and you can also make your own dividend by selling shares.

When deciding between value and growth investing, it’s important to consider your own risk tolerance and investment horizon. Value investing may be a good choice if you are looking for stability and current income and are willing to hold onto investments for a longer period of time. Growth investing may be a good choice if you are looking for high returns and are willing to take on higher risks.

It’s also worth considering a mix of both value and growth investing to diversify your portfolio and potentially lower risk.

Ultimately, the decision between value and growth investing, or whether to have a mix of both, will depend on your specific circumstances, risk tolerance, and investment objectives.

Evaluating different investment styles: Value vs. Growth

Evaluating different investment styles is important in creating a well-rounded investment portfolio. Both styles have their own set of advantages and disadvantages. Let’s take a look at them:

Value investing offers the following:

  • Spotting undervalued but potentially financially strong companies
  • Buying at a discount with some margin of safety
  • More stability and less volatility
  • Likely to be paying dividends
  • Likely to appreciate over the long term though not as much as growth stocks

Growth investing offers the following:

  • Buying stocks of companies that have strong potential for future growth
  • Ignoring the current valuation in anticipation of a much higher valuation in the future
  • Focusing on tech and startup companies that are experiencing rapid growth
  • Sacrificing dividend income for growth
  • Likely to appreciate faster than value stocks
  • The ability to stomach the huge risk

Both value and growth investing strategies have their own set of merits and demerits, so investors need to understand these trade-offs before deciding which approach to take. When evaluating different investment styles, it’s important to consider one’s own risk tolerance, investment horizon, and financial goals. The two investment styles suit different types of investors. Choose the style that you are comfortable with. You can even have a mix of both.

Analyzing the pros and cons of value and growth investing

Value investing and growth investing have their own unique pros and cons. Let’s take a look at them:

Value Investing

The pros include:

  • Lower risk: Value investing is generally considered to be less risky than growth investing as the companies that value investors focus on are often established and have a proven track record of success, which can provide a degree of stability for investors.
  • Dividend income: Value stocks tend to pay dividends, which can provide a steady stream of income.
  • Less affected by market conditions: Value stocks are less affected by short-term market fluctuations, which can provide a degree of stability for investors.

The cons include:

  • Lower returns: The returns for value investing may be lower than those of growth investing.
  • Long-term investments: Value investing requires a long-term investment horizon, which may not be suitable for investors who are looking for short-term gains.
  • Out of favor (not hot or trendy): Value stocks may not be as popular as growth stocks, which means they may not be widely followed by analysts or widely held by institutional investors.
  • Value traps: Many value stocks turn out to be value trap. Warren Buffett once was a “cigar Butt” investor but later abandoned the strategy. The reason? Most of the lowly valued stocks are not a good business. They might go up in the short term, but they are poor long term investments.

Growth Investing

The pros include:

  • High returns: The main advantage of growth investing is that it has a higher potential for appreciation than value investing, and it can provide high returns in a short period of time.
  • Short-term investments: Growth investing is often associated with short-term investments, which may be more suitable for investors who are looking for quick returns.
  • Popular/trendy: Growth stocks tend to be more popular among investors, which can result in greater liquidity and more research coverage.

The cons include:

  • Higher risk: Growth investing also comes with a higher level of risk. Companies that growth investors focus on are often in their early stages and have not yet established a track record of success, so they are more likely to fail or go bankrupt.
  • Volatility: Growth stocks tend to be more volatile and may experience significant fluctuations in value.
  • Unlikely to pay dividends: Growth stocks rarely pay dividends, which means that investors will not receive a steady stream of income from their investments.
  • Unproven business models: many potential growth stocks have a business that plan that might not have been around for a long time.

Assessing Risk and Reward: Value and Growth Investing Strategies

When it comes to investing, one of the most important considerations is the balance between risk and reward. Both value and growth investing strategies have their own unique risks and rewards. You need to understand them to be able to make informed decisions about which approach may be best for your individual circumstances.

Value investing aims to buy undervalued stocks with strong fundamentals, with the expectation that the market will eventually recognize their value. The goal is to buy at a discount and sell at a premium. However, it may take time for the market to recognize the real value of the stock, but while you wait for that, you may be earning dividends along the way.

In terms of risk, value investing is generally considered to be less risky than growth investing. The companies that value investors focus on are often established and have a proven track record of success, which can provide a degree of stability for investors. But the returns for value investing may be lower than those of growth investing.

With growth investing, you are buying stocks of companies that have strong potential for future growth, and you don’t bother whether they are overvalued or not. The aim is to capitalize on the potential for appreciation, which can happen over a short period. So, the main advantage of growth investing is that it has a higher potential for appreciation than value investing, and it can provide high returns in a short period of time.

However, growth investing also comes with a higher level of risk. Companies that growth investors focus on are often in their early stages and have not yet established a track record of success, which can make them more volatile and difficult to predict. Additionally, growth stocks tend to be more volatile and may experience significant fluctuations in value.

Overall, value investing tends to be less risky than growth investing, but also tends to have lower returns. Growth investing, on the other hand, has higher returns but also comes with higher risk.

The Role of Backtesting in Determining the Appropriate Value vs. Growth Mix

Backtesting is the process of simulating an investment strategy using historical data to test how well the strategy would have done in the past. This allows investors to see how the strategy would have performed under different market conditions and to identify any potential weaknesses or strengths.

When it comes to determining the appropriate mix of value and growth investing, backtesting can be a valuable tool for identifying the optimal balance between these two strategies. One way to use backtesting to determine the appropriate value vs. growth mix is to create a portfolio of both value and growth stocks and test how it would have performed over time. This can help you identify the optimal mix of value and growth stocks that would have provided the best returns while also minimizing risk.

For example, you may find that a portfolio that is made up of 60% value stocks and 40% growth stocks would have provided the best returns over a 10-year period. You can use this information to make informed choices about how to allocate your assets. Also, you can use backtesting to identify which value and growth stocks are likely to perform well in the future. By analyzing the past performance of individual stocks, you may identify trends and patterns that may indicate future success. This can help you to identify undervalued value stocks and high-growth growth stocks that may be worth investing in.

Deciphering the Differences Between Value and Growth Investing

Value and growth investing are two different investment strategies that have distinct characteristics. Here are some key differences between the two:

  • Definition: Value investing is the style of buying undervalued stocks with the expectation that their intrinsic value will be recognized in the future. Growth investing, on the other hand, is the idea of investing in companies that are expected to experience high growth in the future.
  • Intrinsic value vs. Future prospects: Value investing focuses on measuring a company’s intrinsic value using its fundamentals, such as its financials, dividends, and management quality. Growth investing, on the other hand, focuses on a company’s future prospects, such as its potential for revenue and earnings growth.
  • Valuation metrics: Value investors tend to use valuation metrics such as price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and dividend yield to identify undervalued stocks. Growth investors, on the other hand, tend to focus on metrics such as earnings per share (EPS) growth and revenue growth to identify high-growth companies.
  • Time horizon: Value investing tends to have a longer time horizon as the value of a stock may not be recognized for several years. Growth investing, on the other hand, tends to have a shorter time horizon as the growth potential of a company may be realized sooner.
  • Returns: Value investing tends to provide more consistent returns over the long term, whereas growth investing may provide higher returns but with more volatility.
  • Risk: Value investing is considered to be a lower-risk strategy as it focuses on companies that are currently undervalued but have strong fundamentals. Growth investing, on the other hand, is considered to be a higher-risk strategy as it focuses on companies that have the potential for high growth but may not yet have a strong track record.

Understanding the Tradeoffs of Value and Growth Strategies

Value and growth investing are two popular investment strategies that have their own set of merits and demerits. Here are some key points to consider when deciding between value and growth strategies:

  • Risk and reward: Value investing is considered to be a lower-risk strategy, as it focuses on established companies that are currently undervalued; however, they may offer less return. Growth investing, on the other hand, is considered to be a higher-risk strategy, as it focuses on companies that have the potential for high growth but may not yet have a strong track record, so it comes with more volatility.
  • Time horizon: if you are more interested in short-term gains, growth investing is more suitable. But if you prefer long-term stable investments, value investing is fine.
  • Market cycles: Value investing tends to perform well, or at least have less risk, during bear markets, when stocks are generally undervalued. Growth investing performs well during bull markets when stocks are generally overvalued.

Assessing Investment Strategies: Value vs. Growth Backtesting

Assessing investment strategies is an important step in determining the appropriate mix of value and growth investments for a portfolio. One method that can be used in this assessment is backtesting.

When backtesting value vs. growth investment strategies, you should do these:

  • identify the risk and return profile of each strategy to determine which style offers the best reward, the benefit of using a combination of both styles, and the appropriate mix of value and growth investments for your portfolio.
  • try to gain insights into the appropriate time horizon for each strategy — for example, value strategies may require a longer time horizon to realize returns, whereas growth strategies may provide returns more quickly.
  • assess the diversification benefits of each strategy, which can help you determine the appropriate mix of value and growth investments for your portfolio.
  • determine how the strategies performed during different market conditions and which one performs better in each market cycle.

Value Vs. Growth Strategy – What Is Best? Backtest, returns, and performance

Often there are two camps in the stock market: those who believe growth is best and those who believe value is best.

Let’s look at the performance of two ETFs that track these two different factors: The ETFs we look at are Morningstar small-cap growth (ISCG) and Morningstar small-cap Value (ISCV).

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We invested 10 000 in January 2001 and let it compound until today. Again, growth outperformed value: 49 040 vs. 42 281:

Both backtests above showed that growth was better than value.

Small-cap vs large-cap value and growth – what is best?

The two Russell ETFs track the large- and mid-cap part of the stock market, while Morningstar tracks small cap. Despite having a shorter time to compound, the small-cap growth stocks outperformed large- and mid-cap growth and value by a wide margin.

The time period covered in the backtest is short, but it may confirm the small-cap factor: over time small-caps have outperformed large-caps.

Growth has been better than Value during the time period we looked at. Is this representative of longer time series? Let’s find out:

Historical returns for growth and value stocks

Since 1926, value investing has returned 1,344,600%, according to Bank of America. During that same time growth investing returned just 626,600%. Case closed.

Forbes Magazine, Do Value Stocks Really Outperform Growth Stocks Over The Long Run?

If we look at periods further back, we see that value has outperformed growth. Recent growth outperformance is an anomaly. Since about 2007, value has underperformed in most countries and sectors. According to JP Morgan, this is the longest drawdown of value stocks since WW2, culminating in 2020 after Covid.

Anchor Capital Advisors, LLC published the following chart in an article called Growth vs. Value: Historical Perspective.

Historical returns for growth and value stocks

Thus, over the long term, we can most likely expect value to outperform growth.

What is riskier – value or growth?

In the stock market, risk is measured as volatility. The more volatility, the more risk. That might be a poor risk measure, but it has become the standard of the industry. Warren Buffett has several times spoken against using volatility as a measure of risk.

However, let’s look at some empirical and data-driven facts since 1960. The table below contains 25 different sectors of the stock market and its performance since 1960:

What is riskier - value or growth?

As you can see, the worst group of stocks has been the smallest companies with the highest volatility. This group has not made any money since JFK was president!

Thus, the riskiest stocks are volatile small-caps.

Clearly, it is best to search among boring stocks with low volatility and low market value.

Small-caps with high volatility have an uncertain business model. When this is the case, it is often difficult to determine the correct valuation. New information and news, therefore, substantially impact the share price.

Within the high volatility group, we also find newly established companies that may present a new idea or perhaps a break with existing businesses. It is challenging to pick the very few stocks that become multibaggers. Therefore, perhaps the best option is to invest defensively in “boring” stocks.

Value and growth rotation strategy and system – backtest and performance

Stocks can be divided in many ways: small vs. large, low volatility vs. high volatility, profitable vs. unprofitable, etc. But probably the most common way to look at it is value vs. growth. These labels are called factors in the stock market, which is a form of investing that targets certain drives of return, in this case, value or growth. Other more known factors might be the Price / Earnings ratio or the small-cap factor. The main idea is that such factors can help boost returns, and perhaps also reduce volatility and price variations.

Value is one of the best-performing factors of all time. Growth has not performed so well, but it has had a terrific last decade, as our previous backtests showed. So a question arises: How can we hold growth when it is outperforming value and sell it when it starts underperforming? (and vice versa). In other words, is there a way we can make rotation or momentum trading system that switches between the two factors?

Below, we are going to define what value and growth is, identify when each one performs better, and develop and backtest a trading strategy.

Defining value and growth

Value is the phenomenon in which securities that appear cheap, on average, outperform securities that appear expensive. This is one of the most widely researched factors by academia.

To identify these stocks, money managers and traders usually rely on ratios such as price-to-book or price-to-earnings ratios. Value stocks tend to be companies in “boring” energy, materials, industrial, and financial sectors. However, the manic-depressive mood of Mr. Market makes sectors both cheap and expensive from time to time.

On the other hand, as you could imagine, growth is the exact opposite of value. Growth stocks are the securities expected to grow earnings and margins faster than the market average, and you usually end up paying a premium for that.

Revenue and EPS growth are common ways to sort this type of stock. They are usually found in “exciting” market sectors such as technology, healthcare, and consumer discretionary.

Historical performance of value and growth

Value and growth tend to perform differently at different times. This becomes evident when we look at the following chart:

Historical performance of value and growth

As you can see, the cycles can be easily distinguished. Value performed better until 1989-90, when the internet bubble began to form. Once the bubble popped in 2000, investors started to look for profits and dividends again, and value stocks made a terrific comeback that lasted around five years.

Then, before the financial crisis began, growth started to outperform value, and it continued that way up to 2012-13, helped by 0% interest rates and quantitative easing. For the following years, neither one seemed to do better than the other until 2018, when growth started rising rapidly and reached bubble levels not seen since 2000. 

Now, as of writing, with rates rising faster than any time in history, and a possible recession on the horizon, value stocks are performing better than growth and some traders expect this to continue for some time.

We know this with the benefit of hindsight, but below, we present a strategy that might help you avoid any predictions and instead just follow the market action. Rather than guessing which one will perform better, we will build a model that takes advantage of each one when it does better.

Value and growth rotation trading strategy and system – trading rules

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PS! This is a weekly trading strategy and system; thus, we use weekly bars.

Value and growth rotation trading strategy (system) – backtest

We started the backtest in 2000, right at the peak of the tech bubble. The data is adjusted for dividends and splits. Here are the returns and performance:

The equity curve looks good. Here are some statistics and metrics:

  • CAGR is 8.96% (value 7.42% / growth 5.60%)
  • The standard deviation is 17.87 (18.33 / 19.27)
  • Maximum drawdown is 52.75% (59.71% / 62.82%)
  • The percentage of positive weeks is 57%

The model works perfectly and does exactly what it is supposed to do: take advantage of the factor performing better at the time. The higher return is also achieved with less volatility and drawdown than the other two factors. We get it all: higher returns and lower risk.

Value and growth rotation system (Switching in between) – conclusion

To sum up, our model is superior in every way to the value and growth factors independently. Instead of focusing on only one factor, holding the one outperforming the other is better. The model does that with a simple ratio and two moving averages.

Value Vs. Growth Strategy – What Is Best? Conclusion

History shows that value has performed better than growth over the last century. We believe it makes sense. Many growth stocks trade at a premium to the market, while value often does the opposite. Growth investors are optimists (and perhaps euphoric), while value investors are pessimists.

Another important fact is that many growth stocks have unproven business models and are more likely to fail.

We presented a value vs. growth trading strategy that rotated between the factors based on short-term momentum. It turns out this very basic trading rule makes better returns than the two factors independently and less risk.

FAQ:

What is the difference between value investing and growth investing?

Value investing involves buying undervalued stocks with strong fundamentals, expecting the market to recognize their value over time. Growth investing, on the other hand, focuses on stocks with high growth potential, regardless of current valuation, aiming for short-term appreciation.

Is value investing suitable for long-term investors, and why?

Yes, value investing is often suitable for long-term investors. It involves holding undervalued stocks with strong fundamentals, allowing investors to benefit from the market recognizing the stock’s value over an extended period, potentially providing stability and income.

How do market cycles impact the performance of value and growth investing?

Value investing tends to perform well during bear markets when stocks are undervalued. Growth investing performs well during bull markets when stocks are overvalued. Understanding market cycles helps investors tailor their strategies to market conditions.

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