“Growth” and “value” are distinctions made between types of equity investments. These style labels are generally pinned to certain stocks, market sectors, and indexes. Some investors may prefer one of these stock selection strategies over the other.
Growth investors seek companies that they believe have the potential for above-average earnings growth, perhaps due to innovative technology, a popular product, or any other competitive advantage. Meanwhile, value investors try to identify stocks that may be undervalued because they have fallen out of favor in the marketplace despite having solid underlying fundamentals.
It’s been said that growth and value investments are like two sides of the same coin. Recognizing the key differences between these approaches may help you make more informed investing decisions.
Elements of Style
There is no clear-cut formula that places a particular stock in one category or the other, but quantifiable data such as the price-to-earnings (P/E) ratio and the price-to-book (P/B) ratio is usually where the analysis begins. More esoteric factors such as market sentiment (fear or optimism) can occasionally make it more difficult to classify stocks by style.
Growth stocks generally have higher P/E and P/B ratios than value stocks. Fast-growing companies also tend to reinvest profits rather than pay dividends. Their stocks may be more expensive relative to their current earnings or assets because investors are often willing to pay more if they think earnings growth will continue to drive up the share price. Consider that investments offering the potential for higher returns are also associated with a higher degree of risk.
Typically, value stocks are bought at low share prices compared with industry peers or their own historic averages. They may be more likely than growth stocks to pay dividends to shareholders. When purchasing a value stock, the expectation is that the share price will bounce back in the future when other investors recognize its true value. Of course, it’s possible that the depressed stock price is the result of real problems in the company or the industry, in which case it may not be able to recover.
Combining Forces
For the 20-year period ending in 2012, the average annual return for large-cap value stocks was almost 2% higher than the average annual return for large-cap growth stocks. Yet it’s important to note that growth outperformed value in eight of those years (see chart).
Past performance is no guarantee of future results. The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.
Value and growth stocks tend to outperform during different stages of the business cycle, and shifts in economic or market conditions are usually evident only in retrospect. Taking advantage of appropriate investing opportunities in both categories may help broaden the return potential, smooth volatility, and manage the degree of risk in your equity portfolio.
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