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Investors are constantly faced with the decision between risk and return. The same logic applies to growth versus value stocks. Rationale investors will agree that picking a quality stock is important, but not everyone agrees that value is more important than growth.
Here, we explore the concepts of growth and value stocks, identify their distinguishing features, and highlight the qualities of ideal investors suited for each approach.
Growth vs. Value Stocks at a Glance
Growth Stocks | Value Stocks | |
|---|---|---|
Company life cycle | Primarily in the growth or expansion phase | Generally, in the more mature phases of the business cycle |
Investment style | Focus on companies with high growth potential | Focus on undervalued companies with stable earnings |
Risk profile | Higher risk due to volatility | Lower risk due to stability |
Capital gains | Potential for higher capital appreciation | Lower potential for capital gains |
Dividends | Most do not pay dividends, and those that pay, pay low | More likely to pay dividends and offer a higher yield |
Price | Overvalued – higher PE ratio | Undervalued – lower PE ratio |
The perfect investor | Investors with a higher risk appetite | Conservative and income-seeking investors |
Investor Decision: Growth or Value?
One of the nice features of the stock market is the range of choices investors have when making an investment decision. Unfortunately, this flexibility also results in tough decisions too; especially when it comes to fundamental investment strategies such as the choice between growth and value. To help make that decision a little easier, let's look at each investment type in more detail.
Growth Stocks
Generally, a growth stock is expected to generate earnings at a rate that exceeds the industry's average. Growth companies usually possess a competitive advantage that allows them to generate these above-average profits. This might include a patent, manufacturing scale, or loyal customers.
Growth stocks tend not to pay dividends. Instead, they will quickly reinvest profits into new capital projects that will further increase profits. Growth investors pay little attention to the stock's price, only its future earnings potential.
Identifying Growth Stocks
The easiest way to identify these stocks is by looking at their historical earnings growth rate. The rate for a specific company can then be compared to its industry average.
In June 2011, Apple Computer was an excellent example of a growth stock. The company experienced five-year earnings per share growth rate of 58.8%, which was well above its industry average. The company did not pay a dividend and had projected earnings of nearly $25.00 per share.
Value Stocks
The idea of value investing is rooted in Benjamin Graham's work. The strategy behind this concept is to select stocks that appear to be underpriced by the market. This may include companies that have low price-to-earnings ratios or high dividend yields.
Because value stocks are selling at relatively low ratios, investors feel the market is ignoring these companies. Investors believe such stocks are “bargains” since they are priced below what fundamental analysis would indicate a “fair” amount.
Identifying Value Stocks
Investing in these stocks involves identifying excellent companies with high intrinsic value. These companies have a history of stable earnings and high return on equity and provide high earnings relative to risk-free investments.
In June 2011, AT&T was an excellent example of a value stock. The company experienced five-year earnings per share growth rate of 17.7%. The current ratio was 0.74, the return on equity was 17.90%, and the dividend yield was 5.61%. AT&T also had a relatively low price-to-earnings ratio of 8.98.
Growth vs. Value Stocks Performance
The performance of any stock varies over time, so when comparing the historical performance of growth vs. value stocks, time horizons and the endured risk to achieve these performances must be parts of the evaluation.
That being said, one should note that past performance is never a guaranteed indicator of future performance.
In theory, value stocks are less risky because they belong to companies with solid fundamentals and stable earnings. They often pay substantial dividends, providing a potential income stream to investors. Even if the value stocks don't meet the investor's target price expectations fully, they can still offer stability and potential capital appreciation over the long term.
In contrast, growth stocks generally do not pay dividends, as most of them use the retained earnings for expansion and reinvestment into their businesses. Theoretically, this should indicate a higher appreciation potential, but only if the company’s growth prospects materialize.
If the growing company’s expansion or innovative product release doesn’t meet expectations or faces challenges, the growth stock's performance can be negatively impacted. Therefore, while growth stocks are considered to be the more rewarding of the two, they are also the riskier option.
Depending on the specific time period in history and the prevailing stock market conditions, either growth stocks or value stocks may outperform the other. Many studies indicate that value stocks have historically provided higher long-term returns than growth stocks, with dividends being one of the primary contributors to their performance.
In more recent history, value stocks have been the outperformer in the first ten years of the 2000s, but growth stocks have been outperforming over the last ten years.
The Perfect Investor for Growth Stocks
While both growth and value stocks offer investors opportunities for returns, growth investing calls for the following characteristics and preferences.
High risk tolerance
An ideal growth stock investor demonstrates the ability to embrace the inherent risks and volatility associated with these investments, acknowledging that short-term market fluctuations are a natural part of pursuing potential long-term profits.
Long-term investment horizon
A growth stock investor with a long-term perspective understands that the true potential of these stocks may require time to materialize. They possess patience, willing to hold onto their investments for an extended period to allow the company's growth prospects to unfold and potentially yield substantial returns.
Focus on capital appreciation over steady income
Rather than seeking regular income from dividends like value stocks, an ideal growth stock investor prioritizes the company's growth potential and its ability to generate significant capital appreciation over time. They recognize that these stocks reinvest earnings into the business to fuel future growth.
Strong research and analytical skills
A growth stock investor has strong research and analytical skills to identify companies with the highest growth potential within emerging industries expected to experience rapid expansion.
Confidence in investment decisions
Lastly, a confident growth stock investor demonstrates a deep understanding of the companies they invest in, supported by thorough analysis. They are well-versed in financial metrics, industry dynamics, and the growth potential of the selected stocks, enabling them to stay committed to their investment strategy even during market fluctuations.
The Perfect Investor for Value Stocks
On the other hand, investing in value stocks is inherently different, and as such, it caters to a completely different type of investor. The perfect value investor should have the following.
Appreciation for consistent income
Value investors prioritize investments that offer regular income streams, such as dividends, enabling them to receive steady returns even during periods of slow business growth.
Preference for stable stock prices
The ideal value investor seeks out stocks with minimal price fluctuations, as stability in business conditions leads to lower volatility in share prices, aligning with their desire for predictable investment outcomes.
Strong market analysis skills
A skilled value investor recognizes that a low stock price does not automatically signify an undervalued opportunity. They carefully analyze whether the low valuation results from genuine undervaluation or a reflection of potential challenges in the company's future prospects.
Focus on timely returns
The perfect value investor aims to realize returns on their investment in undervalued stocks sooner rather than later. They actively search for companies that have the potential to outperform competitors, making strategic moves that lead to appreciation in stock value before the broader market identifies the trend.
Ability to spot investment opportunities
In addition to the above qualities, the perfect value investor has a keen eye for identifying promising investment opportunities. They have the ability to purchase undervalued stocks in significant volumes before the market catches on, enabling them to capitalize on the full potential of their investments.
Final Words
These two strategies also reveal the underlying viewpoint of each investor type. Value investors rely on the perspective that the future will be brighter for their stocks, while growth investors are hoping that historical performance continues into the future.
The downside of the value approach is there could be a very good reason a company is underpriced by the market. The downside of the growth approach is that past performance may indicate the run-up in a stock's price is over.
We've also seen that growth companies provide greater returns to investors. Value companies achieve greater stability of earnings, and provide investors with a steady source of income in the form of dividends. In the end, neither group is a standout.
Fortunately, we don't have to choose one type of stock over the other. We can leverage the knowledge we have about their strengths and weaknesses to build a portfolio of stocks that suits our needs and risk tolerance. In fact, blended mutual funds are a great example of an offering that balances the pros and cons of each investment type.
FAQ
What percent of the S&P 500 is growth vs value?
Do value or growth stocks do better in a recession?
Which is riskier, growth or value stocks?
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