I’ve been receiving several questions lately regarding the growth vs. value style debate. At different periods of time, the stock market appears to favor one or the other - value stocks or growth stocks. There is historical evidence that value stocks have outperformed growth stocks over the long term, however, since the 2008 market downturn growth stocks have outperformed.
Recently, there is speculation that value stocks could be making a comeback however, these speculations, do not guarantee future performance and returns are volatile.
Several common valuation metrics ratios have been used to identify value versus growth securities. A partial list includes price-to-earnings (P/E), price-to-book (P/B), price-to-cash flow (P/C), and price-to-sales (P/S).
What Is Value Investing?
The idea behind value investing is that investors are, essentially, bargain hunting. They’re looking for stocks that they believe are being undervalued by the market. It is based on the premise that paying less for a set of future cash flows is associated with a higher expected return. That’s one of the most fundamental tenets of investing looking for stocks undervalued by the market.
If a value investor considers a stock to be underpriced, it’s an opportunity to buy. If they consider it overpriced, it’s an opportunity to sell. Once they purchase a stock, value investors seek to ride the price upward as the security returns to its “fair market” price – selling it when this price objective is reached.
Risks of Value Investing
There’s no guarantee that a stock will appreciate in value as much as an investor expects it to. A stock an investor believes to be undervalued may remain undervalued, or even drop in value. As we have experienced since 2008, the value premium has experienced periods of underperformance although there is precedent for the value premium turning around quickly after periods of underperformance.
What Is Growth Investing?
Growth investing essentially uses today’s information to identify tomorrow’s strongest stocks. The idea is to look for strong earnings growth - stocks of companies within industries that are expected to experience above average growth.
Growth investors seek companies in a position to generate revenues or earnings greater than what the market expects. When growth investors find a promising stock, they buy it, even if it has already experienced rapid price appreciation, in the hope that its price will continue to rise as the company grows and attracts more investors.
Growth investors are more concerned about whether a company is exhibiting behavior that suggests it will be one of tomorrow’s leaders; they are less focused on the value of the underlying company.
For example, growth investors may favor companies with a sustainable competitive advantage that are expected to experience rapid revenue growth, that are effective at containing cost and that have an experienced management team in place.
Risks of Growth Investing
Growth investments may have an above-average price-to-earnings ratio (PE ratio), but they may in some cases be prone to higher volatility than value investments and additionally they typically do not offer dividends. These investments are typically bought at an already high price, and there’s always a risk that the price will fall or cease to rise any further. They are sensitive to business cycles and perform best during “boom” periods.
Value investing and growth investing follow the same general purpose - to buy low and sell high. While they can often overlap in criteria, the key difference between these two guiding principles is this value investing looks for stocks undervalued by the market while growth investing seeks stocks that will grow faster than the market expects. In other words, both investment types are banking on the assumption that the price will rise, but for different reasons.
You may find that a mix of value and growth investments could provide a healthy and diverse assortment. Work with your investment advisor to develop a strategic plan before making any decisions regarding your portfolio.