The biggest driver of long term returns is return on capital, not valuation
“Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.” Charlie Munger
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The Argument
People who invest in stocks can be grouped into two categories: growth investors and value investors. Growth investors invest in small, emerging companies that are projected to make above-average earnings compared to the rest of their respective industry. If these companies are successful, then investors can make large amounts of money, but there is also much risk associated with this because it is hard to predict how a company will perform in the long-run.
The key characteristics of growth funds are as follows:
Higher priced than broader market. Investors are willing to pay high price-to-earnings multiples with the expectation of selling them at even higher prices as the companies continue to grow.
High earnings growth records. While the earnings of some companies may be depressed during periods of slower economic improvement, growth companies may potentially continue to achieve high earnings growth regardless of economic conditions.
More volatile than the broader market. The risk in buying a given growth stock is that its lofty price could fall sharply on any negative news about the company, particularly if earnings disappoint Wall Street. [1]
Growth investing is superior to value investing due to its compounding for the long term. While there is much risk, there is also the chance of a higher return.
Counter arguments
Value fund managers look for companies that have fallen out of favor but still have good fundamentals. The value group may also include stocks of new companies that have yet to be recognized by investors.
The key characteristics of value funds include:
Lower priced than broader market. The idea behind value investing is that stocks of good companies will bounce back in time if and when the true value is recognized by other investors.
Priced below similar companies in industry. Many value investors believe that a majority of value stocks are created due to investors' overreacting to recent company problems, such as disappointing earnings, negative publicity or legal problems, all of which may raise doubts about the company's long-term prospects.
Carry somewhat less risk than broader market. But, as they take time to turn around, value stocks may be more suited to longer term investors and may carry more risk of price fluctuation than growth stocks.[1]
Value investing is superior to growth investing because one can buy low with the potential of earning much back in return.