Two Philosophies of Equity Selection
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Value investing and growth investing represent the two dominant philosophies of stock selection, each with a long intellectual history and a substantial body of supporting evidence.
Value investing seeks companies trading below their intrinsic worth — businesses the market has mispriced due to short-term pessimism, neglect, or misunderstanding. The discipline originates with Benjamin Graham, who developed the concept of intrinsic value and the margin of safety in his 1934 work Security Analysis. A value investor buys a £1 asset for 70 pence, accepting a modest business in exchange for a compelling price.
Growth investing seeks companies with the potential to compound earnings rapidly over time — businesses whose future size and profitability will dwarf their current valuation. A growth investor pays a full or high price for a business, accepting the price in exchange for superior future growth. The philosophy is most closely associated with Philip Fisher, whose 1958 book Common Stocks and Uncommon Profits argued that the greatest investment returns come from holding exceptional businesses for the long term.
The Value Premium
The Fama-French three-factor model (1992) identified a systematic return premium for value stocks — defined as stocks trading at low prices relative to their book value — over growth stocks. Empirically, across many markets and time periods, a portfolio of cheap stocks (high book-to-market ratios) has tended to outperform a portfolio of expensive stocks. Fama and French attributed this to the greater risk of value stocks — they are often financially stressed or cyclically depressed businesses.
However, the value premium has been inconsistent in practice. During the decade following the 2008 financial crisis, growth stocks — particularly US technology companies — dramatically outperformed value stocks. The period challenged whether the value premium was a genuine risk premium, a market inefficiency, or a data artefact from a specific historical period.
Growth at a Reasonable Price
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Most experienced investors recognise that the growth/value dichotomy is a simplification. Warren Buffett — a self-described student of Benjamin Graham — famously said that the best business to own is a wonderful company at a fair price, rather than a fair company at a wonderful price. This blending of disciplines has been characterised as GARP: Growth at a Reasonable Price.
GARP investors seek companies with above-average growth prospects that are not so expensively priced as to embed all possible optimism in the stock price. The key metric is the price/earnings-to-growth (PEG) ratio, introduced by Peter Lynch in his 1989 book One Up on Wall Street: a stock with a P/E of 20 growing at 20% annually has a PEG of 1.0, which Lynch regarded as fairly valued; a PEG below 1.0 suggests growth is available at a discount.
The Role of Interest Rates
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One structural reason for the dominance of growth stocks in the 2010s was the extraordinarily low interest rate environment. Growth stocks — particularly technology companies with most of their cash flows in the distant future — are particularly sensitive to the discount rate. At very low discount rates, those distant cash flows are worth a great deal in present value terms. When rates rise, the same future cash flows are discounted more heavily, reducing their present value and weighing disproportionately on growth stock valuations.
The 2022 rate-hiking cycle validated this theoretical relationship empirically: growth stocks fell far more sharply than value stocks as real interest rates rose from deeply negative to significantly positive.