Growth vs. Value: Two Approaches to Stock Investing
Growth and value are two fundamental approaches in stock and stock mutual fund investing. Many growth stock mutual fund managers look for stocks of companies that they believe offer strong earnings growth potential, while value fund managers look for stocks that appear undervalued by the marketplace. Some fund managers combine the two approaches.
Growth and Value Defined
Growth stocks represent companies that have demonstrated better-than-average gains in earnings in recent years and are expected to continue delivering high levels of profit growth. While earnings of some companies may be depressed during periods of slower economic growth, growth companies may potentially continue to achieve high earnings growth regardless of economic conditions. "Emerging" growth companies are those that have the potential to achieve high earnings growth, but have not established a history of strong earnings growth.
Value stocks generally have fallen out of favor in the marketplace and are considered bargain-priced compared with book value, replacement value, or liquidation value. Typically, value stocks are priced much lower than stocks of similar companies in the same industry. This lower price may reflect investor reaction to recent company problems, such as disappointing earnings, negative publicity, or legal problems, all of which may raise doubts about the companies’ long-term prospects. The value group may also include stocks of new companies that have yet to be recognized by investors.
The primary measures used to define growth and value stocks are the price-to-earnings ratio (the price of a stock divided by the current year’s earnings per share) and the price-to-book ratio (share price divided by book value per share). Growth stocks usually have high price-to-earnings and price-to-book ratios, which means that these stocks are relatively high-priced in comparison with the companies’ net asset values. In contrast, value stocks have relatively low price-to-earnings and price-to-book ratios.
Defining Features of Growth and Value Stocks
- Higher priced than broader market
- High earnings growth records
- More volatile than broader market
- Lower priced than broader market
- Currently priced below similar companies in industry
- Carry somewhat less risk than broader market
Growth and Value Are Complementary
Following a specific investment style, such as growth or value, provides investment managers with guidelines for choosing stocks. Growth fund managers look for high-quality, successful companies that have posted strong performance and are expected to continue to do well, though there are no guarantees. Investors are willing to pay high price-to-earnings multiples for these stocks in expectation of selling them at even higher prices as the companies continue to grow. The risk in buying a given growth stock is that its lofty price could fall sharply on any negative news about the company, particularly if earnings disappoint Wall Street.
Value fund managers look for companies that have fallen out of favor but still have good fundamentals. They buy these stocks at bargain prices below the stocks’ average historic levels or below the current levels in their industry groups. Many value investors believe that a majority of value stocks are created due to investors’ overreacting to negative events. The idea behind value investing is that stocks of good companies will bounce back in time when the true value is recognized by other investors. But this recognition of value may take time to emerge and, in some cases, may never materialize.
Which strategy — growth or value — is likely to produce higher returns over the long term? The battle between growth and value investing has been going on for years, with each side offering statistics to support its arguments. Some studies show that value investing has outperformed growth over extended periods of time on a value-adjusted basis. Value investors argue that a short-term focus can often push stock prices to low levels, which creates great buying opportunities for value investors.
Combining Growth and Value
For many mutual fund investors, however, there may not be an absolute advantage to any single approach to investing over a long period of time. Instead of choosing only one approach, individual investors may strive for the best-possible returns with the minimum risk by combining growth and value investing. This approach allows investors to potentially gain throughout economic cycles in which the general market situations favor either the growth or value investment style. For example, value stocks, often stocks of cyclical industries, tend to do well early in an economic recovery; growth stocks, on the other hand, tend to lead bull markets, which are normally fueled by falling interest rates and increased company earnings. Also, because the two groups of stocks tend not to move in the same direction or to the same extent, investors can enhance return potential and reduce risk by combining the two approaches.
Points to Remember
- Growth and value are two approaches, or "styles," of investing in stocks.
- Portfolio managers use an investment style to describe their rules for selecting securities.
- Value investors seek stocks that are priced near or below the value of the company’s assets. Growth investors seek companies that are growing earnings rapidly.
- Because they take time to turn around, value stocks may be more suited to longer-term investors and may carry more risk of price fluctuation than growth stocks.
- Individual investors who purchase mutual funds can combine the two investment styles to help lower risk.