Fundamentals of Value versus Growth Investing and an Explanation for the Value Trap

Value stocks earn higher returns than growth stocks on average, but a “value” position can turn against the investor. Fundamental analysis can explain this so-called value trap: The investor may be buying earnings growth that is risky. Both the earnings-to-price ratio (E/P) and the book-to-price ratio (B/P) come into play. E/P indicates expected earnings growth, but price in that ratio also discounts for the risk to that growth; B/P indicates that risk. A striking finding emerges: For a given E/P, a high B/P (“value”) indicates higher expected earnings growth—but growth that is risky. This finding contrasts with the standard convention that considers a low B/P to be “growth” with lower risk.