Value vs Growth vs Momentum: Bear Markets and High Inflation

Investors often describe themselves by style: value, growth or momentum. Each style is a set of rules about what to buy and why. Each also has research behind it, and each has gone through years where it lagged. Understanding the logic of each, and where it can fail, is more useful than choosing a favourite.

Value investing

Value investors buy stocks that look cheap relative to the business, measured by ratios such as price-to-earnings, price-to-book or dividend yield. The idea goes back to Benjamin Graham and David Dodd in the 1930s: a share is a part-ownership of a business, and its price can drift below what the business is worth. The gap is the margin of safety. Warren Buffett, a student of Graham, later shifted toward buying higher-quality businesses at fair prices rather than only the cheapest.

The academic evidence comes from Eugene Fama and Kenneth French. Their 1992 paper in the Journal of Finance reported that firm size and the book-to-market ratio, rather than market beta, explained much of the differences in average stock returns in US data. Their later three-factor model added a value factor, built from stocks with high book-to-market ratios, to the market and size factors. They interpret it as compensation for risk. Other researchers argue that it reflects investor behaviour. The debate is still open.

The risk is the value trap: a stock is cheap because its business is deteriorating, and it can stay cheap or become cheaper. Value has also gone through long spells of weakness. In many widely used US indices, growth stocks outperformed value for much of the 2010s, before the picture reversed in 2022. A premium found in long data samples can disappear for a decade.

Growth investing

Growth investors buy companies whose earnings or revenue are expected to rise much faster than the average, and they accept high valuation ratios in exchange. They are betting that the growth will be larger or longer-lasting than the price already assumes. Peter Lynch popularised a middle path, growth at a reasonable price, which uses the PEG ratio described in the stock screening article.

The risk is that high prices leave little room for disappointment. If growth slows, even if it stays positive, the price can fall sharply as the multiple the market pays contracts. Growth stocks are also more sensitive to changes in interest rates, for a mathematical reason: more of their value sits in cash flows far in the future.

A cash flow ten years away loses about a sixth of its present value when the discount rate rises from 4% to 6%, while one arriving next year barely changes. A company with a larger share of earnings far in the future is exposed to this effect. It is one reason growth and value have often reacted differently when interest rates rose.

Momentum investing

Momentum investing buys assets that have recently risen and avoids or sells those that have recently fallen, on the premise that trends tend to persist for a while. It does not look at valuation. Narasimhan Jegadeesh and Sheridan Titman's 1993 paper in the Journal of Finance found that strategies buying past winners and selling past losers earned significant abnormal returns over holding periods of about 3 to 12 months in US data. They also reported that part of the gain faded in the following two years.

Explanations include investors reacting slowly to news and herding behaviour, and risk-based explanations are also argued. The risk is that momentum can reverse suddenly. Research by Kent Daniel and Tobias Moskowitz on 'momentum crashes' found that the strategy has suffered sharp losses when markets rebounded after a bear market, since previous losers can rally hardest. It also trades often, so costs matter. Momentum is related to the trend-following ideas in trend following versus counter-trend trading.

These are tendencies observed in historical data, and they depend on how each style is defined, which market is used and which years are measured. Past results do not promise future ones, and none of these styles has a guaranteed edge.

Bear markets

A bear market is conventionally defined as a fall of 20% or more from a recent peak. They vary greatly. The S&P 500 fell about 57% from October 2007 to March 2009, over roughly a year and a half. The decline in early 2020 was about 34% from the February peak to the March low, in around five weeks, and it recovered in months. Other bear markets have taken years to recover.

Styles behave differently depending on the cause. In a sharp, broad sell-off, most stocks fall together, and a style's relative advantage matters less than the size of the overall loss. Momentum tends to carry a short-term risk at turning points, because the leaders of the old trend are often the first to fall and the first to rebound. Defensive sectors such as healthcare and consumer staples have often held up better in recessions, and cyclical sectors have often led early in recoveries. These are tendencies, and each cycle differs.

Behaviour is the main danger in a bear market. Selling after a large fall locks in the loss, and buying every dip can lead to further losses if the decline continues. The buy-the-dip article looks at why. Having a written plan before a decline starts makes it easier to follow.

High inflation

Inflation affects stocks in two main ways. First, central banks tend to raise interest rates to fight it, which raises discount rates and pressures long-duration assets, as the arithmetic above shows. Second, companies face higher costs and need to decide whether they can pass them on. A business with pricing power, such as strong brands or products with few substitutes, can raise prices without losing many customers. A business with thin margins and rising input costs may see profits squeezed.

In the 1970s, high inflation coincided with weak real stock returns in the United States, while energy and commodity producers did better. In 2022, when inflation rose and rates climbed quickly, many growth stocks fell sharply while energy shares gained. These episodes suggest that sector composition, interest rates and pricing power matter, but two episodes cannot establish a rule. The causes of each inflation differ, and so do the responses.

One practical test of whether a company can cope with inflation is its record of stable or rising margins in years when costs rose. Other checks include moderate debt, because refinancing costs more when rates are high, and demand that holds when prices go up. None of them guarantees a result.

It helps to separate two questions when judging any style: whether the effect existed in the past, and whether it can be collected after costs in the future. Published research reports gross results for idealised portfolios. A real investor pays spreads, commissions and taxes, and the more a style trades, the more of the apparent edge these costs consume. Effects that become widely known can also shrink once many investors act on them.

Putting it together

• Know which style you are using and what would make it fail, since each has a clear weak spot.
• Diversify across styles, sectors and countries rather than depending on one, because leadership rotates unpredictably.
• Keep costs and turnover in view, because trading often can erase a small edge.
• Size positions so that a long period of underperformance is survivable.

Share CFDs add leverage and financing costs to whatever style you follow, and they are a contract with a broker rather than ownership of the shares. This article is educational, and none of it recommends a style or a stock.

Sources: Fama and French (1992), 'The Cross-Section of Expected Stock Returns', Journal of Finance 47(2); Jegadeesh and Titman (1993), 'Returns to Buying Winners and Selling Losers', Journal of Finance 48(1); Daniel and Moskowitz (2016), 'Momentum Crashes', Journal of Financial Economics; S&P Dow Jones Indices (S&P 500 historical levels); Graham and Dodd, Security Analysis. Next in the series: ETFs, All-Weather Portfolios and Managing FX Risk