On May 27th 1933, President Franklin D. Roosevelt signed the Securities Act of 1933. To say that this piece of legislation was groundbreaking would be an understatement. One of the many mandates in the act was that publicly traded companies must register with the newly created Securities & Exchange Commission and produce accurate financial statements for investors and the public to examine. One year later the book “Security Analysis”i co-written by the great Benjamin Graham was published (Graham was a mentor to Warren Buffet). In his book Graham made specific distinctions between investing and speculating. He also laid the groundwork for what would come to be known as “Value Investing”. Here, Graham proposed a mathematical framework for evaluating a stock price based on the company’s financial statements.
At some point in the mid twentieth century the value approach started to be challenged by a new approach: growth investing. This was in-part fueled by the new technology stocks of the day like Kodak, Xerox, and IBM. Some of theses younger companies had less than impressive balance sheets, but the technologies they offered were undeniably important so they attracted a lot of investment.
Another factor that gave a boost to “growth investing” was the rise of passive investing and index funds. With this approach investors could buy an entire market rather than just a single component. However the entire market will always contain stocks that are overvalued and shunned by value investors. Depending on your investment objectives and risk tolerance, the risk associated with speculative stocks may potentially be reduced if they are included in well diversified portfolio. Sure, any one stock can go bankrupt, but could the entire technology sector disappear? The impact of passive investing has been amplified by the rise of the 401(k). Many retirement accounts use exchange traded funds or “ETFs” to capture large portions of the market, including stocks who’s balance sheets are less than sound.
When you consider the increasing pace of technological advancement and the race to capitalize on it, the rise of passive investing and the 401(k), it is easy to see why growth stocks have gotten a lot of attention. However, the long-term trend between “growth” and “value” stocks are more similar than one might think. The “spread” between the two over the last three years has been very wide compared to long term trends. Growth should outperform Value over very long periods of time, but the numbers we are seeing today are hard to rationalize. For the current spread to narrow and look more familiar, recent trends will have to reverse.