The investment universe is massive. As an investor, it’s up to you to make several critical decisions regarding the investments you add to your portfolio. To further simplify the process, scholars and investment professionals have come up with countless ways of classifying different asset classes. Understanding these different classifications, such as growth vs value stocks, can help you make more sense of the investing options on the table.
Equities can be broadly classified in two different ways:
- Size (Market value)
- Style (Growth vs Value)
This article will provide you with context surrounding the latter of the two.
As a reminder, the information in this publication is educational in nature. Investing is a personal process with real money at stake. As such, always keep your own circumstances and goals in mind before making any investment decisions. If you have questions about your situation, you should always consult a licensed professional before you make a final decision.
What Is Style?
Style refers to an investor’s security selection process. No two investors’ processes are the same, nor should they be.
In the world of equities, we have two widely-accepted styles of investing: growth vs value.
Whether you own individual companies in your portfolio or use a mix of passive and active funds, it’s important to understand each style.
A lot of research has gone into which of the two styles is better.
As with almost everything else in the finance world, the answer is vague: It depends.
Each investing style has its own pros and cons. Furthermore, there are several personal variables to consider when looking at growth vs. value stocks, such as your:
- Risk tolerance
- Investment time horizon
- Investment goals and preferences
- Sentiment about the economy and broader market
What are Growth Stocks?
Simply put, a growth stock is a share offered by a company that is growing faster than their industry counterparts and/or the economy.
Growth tends to refer to increases in earnings, revenues, profits, etc. Thereby, growth stocks tend to belong to up-and-coming industries that have the attention of consumers.
These companies focus on one thing: aggressive expansion of their business model. Growth stocks typically (though not always) reinvest their profits back into their business models in order to scale their operations. The cash flows may go toward a variety of purposes such as marketing, acquisitions, research and development, etc.
As such, shareholders of growth companies are rarely receive a dividend. This is something to consider if you are an income-oriented investor.
An easy way to identify a growth company is by analyzing its P/E Ratio. As a reminder, P/E measures a company’s current stock price to its Earnings Per Share.
Growth stocks tend to have highly inflated P/E ratios.
Investors pile a lot of money into these stocks because they believe the futures of these firms are bright, even if their current levels of earnings and profits don’t reflect it. As such, this can lead to inflated share prices.
What Are The Benefits of Growth Stocks?
There is a lot of money in owning the right growth stocks. While it’s impossible to determine whether an up-and-coming company will pan out, all you have to do is look at Netflix in order to see a real example of the power of growth stocks.
Growth companies and funds tend to make sense for investors that are tolerant to risk and have time on their side. All things equal, it would be logical for a younger investor to have a greater amount of exposure to growth companies than an older investor.
Capital appreciation is the primary benefit of owning these types of companies. If your financial goals require extensive appreciation in portfolio value, you may want to consider this style of investing.
What Are The Risks Involved With Growth Stocks?
While growth stocks are attractive due to their potential, they are not free from risk. In fact, many professionals consider growth stocks riskier than their value counterparts.
Because these types of companies focus on scaling their business operations, they are likely to over-leverage. This means that they use a lot of debt to finance their model, on top of reinvesting profits. If a growth company does not have a healthy amount of cash or strong profits on their balance sheet, they may face bankruptcy in a recession due to their inability to service the debt.
It’s not always the case, but many growth companies belong to industries that rely on consumers having access to excess disposable income. In the next recession, consumers are going to be more concerned with purchasing consumer staples (things that are a necessity) instead of gadgets or luxury services.
Another thing to consider with growth stocks is the risk of them being overvalued, which happens when a company’s share price has become overly inflated compared to the company’s actual ability to grow its earnings. This means there is a chance that you may buy a company at a price that is not sustainable, thereby exposing you to a great deal of downside risk.
It’s important to note that when it comes to investing in growth vs value stocks, growth options to be more volatile than value companies. Their share prices are susceptible to large swings, especially around earnings announcements.
What are Value Stocks?
Value stocks are shares of companies that are much more mature and established. Many of the “blue chip” companies you’ve likely heard fall into this category.
Unlike growth stocks, which are still up-and-coming, many value companies have done the majority of their growing already. They tend to belong to industries that have moved from the growth phase to the maturity phase.
Value companies are often considered undervalued. This is due to the fact that their current share price is below what analysts consider the firm’s “fair market value” (FMV). FMV can be calculated through a number of methods like the Discounted Cash Flow Model, Dividend Growth Model, etc.
One of the most well-known methods of identifying value companies is the price to book ratio. This measures a firm’s market capitalization (market value) over its book value (value on the company’s books). Value companies are known for carrying lower price to book ratios compared to their growth counterparts.
Value-oriented investors like the idea of purchasing a company below its market value, making them a potential bargain. This is why these companies are referred to as value stocks.
What Are The Benefits of Value Stocks?
The primary upside to value stocks is the potential to acquire a solid company at a discount. Remember, the entire goal of investing is to buy low and sell high. Through careful analysis, skilled investors may be able to uncover companies that have been neglected by the broader market.
Because value stocks tend to be more established in the investing world vs their growth counterparts, they are more likely to pay out a dividend. Instead of reinvesting profits, value stocks tend to pay the cash flows out to investors instead.
Due to their solid financial standing and maturity, an argument can be made that value companies offer investors with better risk-adjusted returns compared to volatile growth companies, especially during periods of economic instability. 9 times out of 10, an established value company has a better chance of withstanding a recession than an aggressively scaling up-and-coming growth company.
From a performance perspective, a lot of research points to the fact that value tends to provide long-term investors with better risk-adjusted returns.
What Are The Risks Involved With Value Stocks?
The most pressing risk with value stocks is missing the financial opportunities that runaway growth stocks can – but don’t always – offer.
In the past decade growth has outperformed value by a substantial margin. This is due to several factors beyond the scope of this article. An investor that was in need of capital appreciation throughout that period could have missed out on some spectacular returns, especially if they owned a couple of the needles in the colloquial haystack.
While value stocks have yielded solid returns long-term, over short periods of time, growth has outperformed value, according to research on the market. Sometimes it may take some time for an investment in a value company to truly pan out.
As Warren Buffett, a known value investor, stated: “Nobody wants to get rich slow.”
How Do I Invest In These Different Styles?
Whether you believe in owning individual companies or you like spreading your risk out out via funds, you have the ability to invest in both growth and value companies in your portfolio.
If you go the individual security route, you will have to do some fundamental analysis in order to identify different companies that meet the criteria you are looking for. There are plenty of great resources available to you like Morningstar, Yahoo Finance, FinancialProfessional, etc.
If you prefer to invest in ETFs or index funds, you have plenty of options as well. All you have to do is queue up a quick google search for a growth or value ETF. You’ll see dozens of options. Make sure that you research aspects of investment such as expense ratios, etc.
If you believe in active management, there are plenty of mutual funds that can also meet your needs. Again, do your research. Look into the manager’s track record, the fund’s top holdings, etc.
There are also “blended” funds which will provide you with exposure to both styles of investing. Blended funds can also vary in market capitalization.
Note: a company can be small, mid-sized, or large and can fit into one (or both) categories.
Growth vs Value Investing: Which is Right for Me?
As always, you should be very aware of what you are trying to accomplish in your investment portfolio. There is no right or wrong answer as to what type of investing style you should adopt.
Growth companies may make sense if you:
- Are a growth-oriented investor;
- Don’t mind volatility;
- And aren’t in need of portfolio income
Contrarily, value companies may make sense if you:
- Are an income-oriented investor;
- Are typically risk-averse
- Want some exposure to equities in your portfolio
Ideally, you’ll have exposure to both styles in your investment portfolio in order to truly take on a diversified approach. Remember, just because one type of investment is currently outperforming the market doesn’t mean it will always outperform. A total return strategy is often one of the best strategies you can employ as a long-term investor.
A Final Word
Out of all the ways you can classify equity investments, growth and value remain among the most widely accepted. Each style has their own pros and cons. While different bodies of research show a preference to one style over another, both types of investments can add value to your portfolio.
A solid understanding of each school of investing can provide you with powerful context as you progress throughout your investing journey.
Give careful consideration to your financial goals, risk tolerance and preferences before adding any sort of investment to your portfolio. Do your research, leverage the tools and technology at your disposal, and do what is best for you.
Questions about growth versus value investing? Let us know!