A MOMENT OF CLARITY
The Difference Between Growth & Value Stocks
BY: THEODORE SCHNEIDER
The stock (“equity”) market contains a vast universe of companies, all of which display varying attributes and fundamentals. As a result, investors have created numerous different approaches to categorize the stock market universe.
Some of the most common approaches include categorizing stocks by sector (i.e. different industries), market capitalization (i.e. size of company), geography, and investment style. The investment style classification focuses on a company’s fundamentals and categorizes stocks within three distinct buckets: value, core or growth. When investing in equities, it is important to understand the differences between the styles, particularly as it relates to growth and value.
What is Value Investing?
Simply put, value investing is a strategy to invest in companies that are relatively inexpensive compared to their own financial standing and that are considered undervalued by the market. Value investors focus on company fundamentals and valuation metrics to distinguish if the company is under or overvalued relative to its true (‘intrinsic’) value. Companies with below-average valuations as compared to their peers, using metrics such as the price-to-earnings ratio or price-to-book value ratio, are considered value companies. Additionally, value stocks often pay dividends and have slower and more stable growth rates. Value stocks are most commonly found in the Financials, Health Care, Consumer Staples and Utilities sectors. A few well-known value companies are JP Morgan Chase & Co., Pfizer and Procter & Gamble.
Value investing tends to perform best during the early and late stages of an economic cycle, either when the market is starting to heat up or cool down. During economic inflection points as well as during volatile episodes, investors typically gravitate to more stable and low valuation stocks, thus benefitting a value investing style. On the other hand, value stocks typically trail during sustained bull markets, when economic and earnings growth is strongest.
Given that many value stocks pay a dividend, value investing follows a total return approach, meaning that the investment return is driven from both income (dividends) and capital appreciation (share price movement). Due to the dividend component and more stable growth aspects of value companies, value investing has historically been less volatile than growth investing over the long-term.
What is Growth Investing?
Growth investing focuses on companies on the other end of the spectrum. Companies with above-average earnings growth, that pay little to no dividends, and that have elevated valuation metrics compared to their peers are considered growth stocks. Growth stocks tend to be more expensive as investors “pay-up” to take part in the company’s higher growth potential (i.e. earnings growth, sales growth, and cash flow growth). Growth stocks appear more heavily in the Information Technology, Consumer Discretionary and Communication Services sectors. A few well-known growth companies are Apple, Amazon, Facebook, and Alphabet (Google).
Contrary to value stocks, growth investing tends to perform best during periods of robust economic growth when corporate earnings are accelerating. Investors prefer growth stocks in a positive economic environment as they present the best opportunity to participate in the growth of the economy. However, when economic conditions falter or cool off, growth stocks usually experience more pronounced declines as investors lose the willingness to pay a higher relative price for stocks with diminished growth potential. Because growth stocks pay little or no dividends, the return profile of a growth stock is composed almost entirely from capital appreciation (share price movement). As a result, growth stocks generally offer the most opportunity for high returns but can also exhibit more volatility and potential for negative returns.
What is Core Investing?
Finally, there is core investing, which can relate to one of two things. A core stock is one that exhibits middle of the road fundamentals. A core stock displays average earnings growth and valuations relative to the rest of the stock market universe and may or may not pay a dividend. Core investing can also refer to investing in a combination of value, growth and core stocks to create a blended portfolio. Many market indexes, such as the S&P 500 Index or Russell 1000 Index, are comprised of a core (or blend) investment style.
How to Invest: Growth, Value, or Both?
Diversified portfolios generally hold a balance of growth, value and core stocks in order to adequately navigate different market conditions. However, during periods of sustained economic strength or weakness, investors may choose to tilt their portfolio towards more growth or value stocks in order to better capitalize on the market conditions.
Investment products, such as mutual funds or ETFs, may follow a distinct style mandate, meaning that they focus the majority of their portfolio holdings in either value or growth stocks. These pooled investment vehicles allow an investor to gain a specific style exposure through a diversified approach.
To discuss how your portfolio should be invested given current economic and market conditions, contact a Round Table Wealth Advisor.
i Price-to-earnings (P/E) ratio is a fundamental valuation metric that measures a company’s share price to its earnings per share. Put simply, the P/E ratio is the price an investor pays for $1 of a company’s earnings.
ii Price-to-book value (P/B or P/BV) ratio is a fundamental valuation metrics that measures a company’s share price to its book value per share. Put simply, the P/BV ratio is the price an investor pays for $1 of a company’s book value.