Value vs. Growth Stocks: Which Is Right For You?
Say you want to map out a plan for building your portfolio that combines different investing strategies. Two of the classic approaches would most likely be in the mix: value investing and growth investing.
Wall Street is fond of classifying stocks under the labels of growth or value. But the truth is that many stocks exhibit elements of both. An ideal portfolio should generally include a blend of value stocks and growth stocks.
Nevertheless, there are fundamental differences between growth investing and value investing, and most investors exhibit a preference for one over the other.
Growth vs. Value Stocks: How Are They Different?
As its name suggests, growth stocks demonstrate rates of growth that outpace the market average. Most commonly, that’s because they offer one-of-a-kind products or are developing disruptive technologies.
Growth stocks tend to be more volatile than other types of companies, with share price fluctuations. Investors buy growth stocks to earn profits from rapid price appreciation, rather than income from dividends.
Value stocks remain steady through all sorts of market conditions and take time to gain in price. But the fundamental attribute of value stocks is the chance to buy shares when they are “undervalued,” or when the market perceives their worth to be less than their intrinsic value.
Conversely, the big idea behind prioritizing growth stocks is the opportunity to enjoy above-average revenue and earnings growth potential.
Should You Value Growth Above All?
Growth companies stress the fast and furious ride from highly promising small businesses to industry leaders.
Their laser focus on growing sales, revenue and cash flow—frequently at the cost of profitability—means that the company’s perceived value can rise quickly. This appreciation can translate into a soaring stock price.
Measured by price-to-earnings (P/E) or price-to-book (P/B) value ratios, growth stocks have high valuations, which should be set against the typically faster revenue and earnings growth as compared with other companies in their industries.
Value Grows on You Over Time
When compared with their earnings and long-term growth potential, value stocks trade at inexpensive valuations. These are stable, sometimes even boring, businesses that generate small but steady gains in revenue and profits.
A company’s business can even be in decline, but if its stock price is so depressed as to lowball the value of its future profit potential, it’s a value stock.
Comparing Growth vs. Value Stocks
- High prices relative to profits make them appear to be more expensive.
- Investors expect impressive growth in sales and cash flow, leading to higher price-to-sales (P/S) and P/E ratios.
- Expectations for companies to deliver on ambitious plans make growth stocks riskier. If those plans don’t pan out, share prices will decline.
- Value stocks are companies that are “on sale.” A low price relative to profits makes them bargains.
- A proven profit-generating machine on the back of a stable business model usually means less risk.
- The downside is if the market has already priced the stock correctly, there may be limited upside.
Which Is Best: Value or Growth?
Both growth and value investing can lead to profitable results for the canny investor. What makes a style best for you hinges on your financial goals and risk tolerance.
Happily, the choice doesn’t have to be so stark.
Warren Buffett, arguably the most famous value investor of all time, rightly pointed out that both strategies are intrinsically linked.
“In our opinion, these two approaches are joined at the hip: Growth is always a component of the calculation of value, constituting a variable whose importance can range from negligible to enormous,” wrote Buffett in his notable 1992 Berkshire Hathaway letter to shareholders.
You Should Choose Growth Stocks If:
- You don’t view your portfolio as a source of income, and you won’t need the money for a while. Growth companies invest their profits in the business to fuel expansion, so they rarely pay dividends.
- You understand that ambitious goals take a long time to achieve, so you can give your stocks all the time they need to live up to their growth promises.
- You believe you can pick winning stocks in competitive emerging sectors. The up-and-coming industry will have dozens or even hundreds of players vying for a significant share of the market. A savvy investor needs to understand the underlying technology well, while being guided by intuition regarding a company’s ultimate prospects.
- You have a high tolerance for risk. With many competitors trying to outdo one another, a company’s prospects can change with the news cycle. Quick changes demand a strong stomach.
You Should Choose Value Stocks If:
- You view your investment portfolio as a source of income. One of the hallmarks of value stocks is the payment of healthy dividends. This is one way for a company to make its stock attractive when the business is not experiencing significant growth.
- You prefer stable stock prices and know how to avoid value traps. Value stocks usually don’t move much in either direction since stable business conditions make for low share price volatility.
- You understand that a low stock price does not always mean a company is an undervalued value stock. Some stocks are cheap for a reason, and a careful investor will understand when a low valuation is indicative of shaky business prospects.
- You want your investment in undervalued stocks to pay off sooner rather than later. While value stocks don’t tend to show quick appreciation, the right company makes the right moves and outmaneuvers its competitors, earning appreciation. The keenest value investors find and buy such stocks at volume before the market notices the trend.
Growth Indexes and Value Indexes
Market indexes track the performance of a group of related stocks, providing a benchmark for investors to understand the performance of different sectors of the economy and the stock market. Popular indexes track both growth and value stocks.
The S&P 500 Growth Index draws its growth stock components from the S&P 500, choosing companies with the best three-year growth in revenue and earnings per share (EPS), plus those that show the strongest upward price momentum.
The S&P 500 Value Index tracks stocks that meet a selection of key growth stock criteria. The index measures value stocks using three factors: book value, P/E and sales to price.
GARP: The Best of Growth and Value
There is an alternative investing strategy that blends aspects of both growth and value investing known as growth at a reasonable price, or GARP.
Famed investor Peter Lynch popularized the strategy. GARP concentrates on growth companies while keeping an eye on the traditional measures of value.
This hybrid seeks out growth companies that are priced in line with their intrinsic value. The key challenge of growth investing is understanding a company’s growth prospects.
For younger companies in fast-changing industries, predicting future growth trends can be very difficult. Even if an investor can arrive at reasonable predictions, it’s still challenging to determine how much they should reasonably pay for that growth.
GARP investors use the price/earnings-to-growth ratio, known as PEG, to determine if a company is reasonably priced given its growth prospects. The PEG ratio is calculated by dividing a company’s P/E ratio by its expected growth rate. A result of one or less indicates that the stock is reasonably priced—a result above suggests the stock is too expensive for a GARP strategy.
Which style is right for you?
Looking at long-term performance, neither the growth nor value approach stands out as an obvious winner.
It’s true that, when economic conditions are favorable, growth stocks tend to outperform value stocks by a small margin. Yet when the economy is in the doldrums, value stocks come out on top.
As is often the case in life, extremes are not desirable. Having exposure to both growth and value stocks can give your portfolio the best of both worlds. Much depends on considerations of time: Where you are in the investor life cycle? How much time you have until retirement? What is the state of the economy at the moment?
Depending on the answer to these questions, choose the investing style that appears to be most consistent with your goals.