By Jim Fink on April 3, 2012

Its common wisdom that value stocks (i.e. stocks sporting a low valuation multiple, such as price-to-book or price-to-earnings) outperform growth stocks (i.e. stocks sporting a high valuation multiple) over the long run.

In fact, I repeated this maxim in my previous article entitled So, You Want to Be a Value Investor? Think Businesslike . where I summarized the findings of an Ibbotson Associates study showing that value stocks outperformed growth stocks by an average of several percentage points per year over a multi-decade period. Other studies by: (1) Fama and French ; (2) Lakonishok, Shleiffer, and Vishny ; and (3) The Brandes Institute reached similar conclusions.

Its More Complicated

Statistics can be tricky. As humorist Evan Esar once quipped, statistics is the only science that enables different experts using the same figures to draw different conclusions. And this value vs. growth debate is a perfect example.

Reformulate vs. Buy-and-Hold makes All the Difference

Heres the deal: value stocks outperform growth stocks over long periods of time only if you reformulate the portfolio of stocks on a periodic basis . These studies do not claim that a long-term buy-and-hold portfolio of the same value stocks outperform a buy-and-hold portfolio of the same growth stocks over decades. For example, take a look at the Ibbotson studys methodology:

Portfolios were formed at June-end of each year . and value-weighted monthly returns were calculated from July to the following June.

Similarly, for the Fama/French methodology: the portfolios are formed at the end of each calendar year from 1974 to 1994, and returns are calculated for the following year. The Lakonishok study had a bit longer holding period of five years, but these authors noted: The superior returns to value strategies persist for at least 5 years (perhaps with some petering out toward years 4 and 5).

There you have it. If you are the type of investor who likes to buy-and-hold stocks for decades, these value studies are worthless, despite the banner headlines of multi-decade value outperformance. Only if you are willing to trade in and out of stocks on a yearly or slightly longer periodic basis, can a simple strategy of buying cheap stocks outperform over the long term.

Buy-and-Hold Growth Outperforms!

So, have any studies been done to determine which style of stocks outperform for the typical long-term buy-and-hold investor? Yes, and the results are the exact opposite of the previously mentioned studies. For holding periods of as little as 8 years, academic studies have determined that a portfolio of growth companies outperforms a portfolio of value stocks. For example, a 2003 study by University of North Dakota finance professor Nancy Beneda looked at an 18-year sample period between 1983 and 2001. Her conclusion:

To truly assess the performance of growth stocks, a long-term horizon assuming a buy-and-hold strategy must be examined. The results indicate that over the first five years or so after portfolio formation, the performance of the growth stocks lags behind that of the value stocks. However, after the seventh or eighth year, the value indexes for the growth stock portfolios, in general, pass up that for the value stocks.

We find that on average equity-only investors with short horizons optimally choose portfolios heavily tilted toward value and away from growth. However, the optimal allocation to value decreases dramatically, and correspondingly the optimal allocation to growth increases, for investors with longer horizons.

The question remains why buy-and-hold growth stocks should outperform buy-and-hold value stocks over the long term. The best way to answer this is to explain the beneficial attributes of growth stocks.

What is a Growth Stock?

A growth stock is a money machine that generates substantial and sustainable positive cash flow and whose revenues and earnings are expected to increase at a faster rate than the average company. A growth company typically has some sort of competitive advantage that allows it to fend off competitors and keep the lions share of business to itself. It also has many different investment opportunities (or a few large opportunities) that promise to generate high returns. These high-return opportunities justify retaining most if not all of the growth companys earnings and not paying them out to shareholders in dividends.

Growth Stocks and Interest Rates

By definition, most of the value of a growth company comes from its future earnings, not from its current asset value. Consequently, a companys value is significantly impacted by changes in the interest rate used to discount future earnings. The higher the time value of money, the more future earnings are discounted and the lower their net present value. The good news is that interest rates are mean reverting, which means they ebb and flow over time and average out in the long run, which reduces risk for the long-term buy-and-hold-investor.

Compounded Earnings Growth Deserves a Premium Price

Growth stocks are not priced cheaply because they possess so many favorable qualities (e.g. consistently growing earnings, competitive advantages, solid and stable business prospects). Consequently, they trade at higher multiples of earnings and book value than other stocks. But dont let these higher prices dissuade you from investing in them! As the incomparable Warren Buffett likes to say: Its far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Wonderful companies quickly outgrow their relatively high valuations and turn out to be bargains. Peter Lynch, the former manager of the Fidelity Magellan fund and another great investor, put it this way in his book One Up on Wall Street :

A 20-percent grower selling at 20 times earnings is (a p/e of 20) is a much better buy than a 10-percent grower selling at 10 times earnings (a p/e of 10). Look at the widening gap in earnings between a 20-percent grower and a 10-percent grower that both start off with the same $1 in earnings: