Week in, week out, we use the terms “growth” and “value” in our articles, and in the documentation that we send out to our clients. We use them so frequently, that perhaps we sometimes lose sight of just how “domain specific” they are.
This week, Associate Investment Analyst Nick Harrington discusses these two approaches to investing… and explains that in times of volatility, being on the right side of that divide can be crucial to ensure returns.
It’s a little subjective…
To a degree, the definitions associated with those terms are somewhat subjective. But more importantly, they are dynamic. And what holds true one month will not necessarily hold true the next month, or indeed the next year. Put simply, when people refer to value stocks, they tend to be referencing an opportunity to buy shares at a price that is somewhat below their “real” value. Growth stocks, on the other hand, have above-average potential in terms of revenue and earnings growth.
Stock markets around the world enjoy classifying stocks as either growth or value. But the picture is actually somewhat more nuanced: many stocks have elements of both. That said, there are clear, significant differences between the two. And some investors have a tendency to prefer one approach to investing over another… or an intelligent blend of the two.
Investors who favour the “growth” approach tend to prioritise small, up-and-coming businesses – the market’s highflyers. They target companies that they believe have the potential to become leaders in their respective sectors as quickly as possible. Such companies are prepared to delay their own profitability. Instead, they focus on building up their revenue. Rather than paying out dividends and rewarding shareholders on a regular basis, they will prefer to reinvest. Then once they have achieved a measure of stability and are on an even keel, they can start to maximise profits.
As those key financial metrics – sales, revenues or earnings – start looking more positive, the value of the company in the eyes of growth-minded investors rises. The result is a virtuous circle of sorts. A rising stock price will enhance a company’s reputation. This will result in even more business opportunities being secured.
Often, growth stocks have relatively high valuations (this is measured by price-to-earnings value ratios). And they tend to be pre-eminent companies in their respective sectors (the Microsofts and P&Gs of the world). But their revenue and income tend to grow faster than that of their peers.
Value stocks are publicly traded companies whose stock price has fallen or remains low. They might be “fallen angels” – stocks which have been reduced to junk status and are trading for relatively cheap valuations relative to their earnings and their long-term growth potential.
They tend to be underrated and there is nothing particularly flashy about their performance. Companies classed as value stocks are often built on tried and tested, reliable and somewhat predictable business models that generate only very modest gains in earnings and revenue over time. Companies that are actually in decline can represent growth stocks. They are trading at such a low price that the true value of their future profit potential is understated.
Growth or value: is one better than the other?
They both constitute lucrative opportunities for shareholders and wise investors. But your own personal financial goals, investing preferences and time horizons will determine which is the better path for you.
Growth stocks are likely to be more appropriate if…
- You are not counting on any kind of dividend income. Growth companies tend not to pay significant dividends to their shareholders. Instead, any available cash gets reinvested directly into the business in a bid to create growth.
- You have the stomach for volatility. Growth stocks tend to be extremely sensitive to any perceived changes in the future prospects of the company in question. When things are going well, they can skyrocket. But conversely, higher-priced growth stocks can plummet just as easily.
- You are confident of being able to pick winners from emerging industries. Growth stocks tend to hang out in fast-moving areas of the economy – like the tech sector. Needless to say, they compete against one another. Your challenge is to select the winners and avoid the also-rans.
- You have a decent time horizon. Growth stocks often take time to fulfil their full potential and there are bound to be stumbling blocks along the way. So it would be best if you had a sufficiently long time horizon – one that will give the company a chance to grow.
Value stocks will appeal if…
- You want your portfolio to deliver some kind of income. Value stocks are known for paying out substantial dividends to their shareholders. Because such businesses lack significant growth opportunities, they resort to other ways of making their stock look attractive.
- You prefer more stable stock prices. Value stocks are typically associated with lower levels of volatility, assuming there are no major upsets and the economy remains within predictable ranges.
- You are good at avoiding value traps. Often, stocks that appear cheap are so for a valid reason, or they are value traps. In some cases, a company may have lost its competitive edge or finds itself unable to keep up with the pace of innovation. Choosing value stocks involves looking beyond attractive valuations to assess a company's future business prospects and determine whether they are good or bad.
- You want returns right away. Value stocks are unlikely to get back onto an even keel immediately. That said, if a company manages to get its business back on track, its stock price can rise quickly. Good value investors excel at identifying and purchasing shares of these stocks before other investors catch on.
Ultimately, in terms of long-term gains, it cannot really be said that one type of stock outperforms the other. When the rest of the economy is doing well, growth stocks tend to modestly outperform value stocks. But value stocks tend to demonstrate more resilience during difficult economic times. Therefore, which category outperforms the other will depend to a great extent on the specific time period you're considering.
It's not set in stone
The various growth and value indices are not hermetically sealed. Indeed, there has been a fair amount of shuffling (and reshuffling) between the S&P 500 Growth Index and the S&P 500 Value Index in recent years. Take traditional growth stock Meta – one of the growth darlings of the 2010s – as an example. Last year saw its stock perform poorly as the likes of PayPal, Netflix and the tech sector more widely bore the brunt of many headwinds worldwide. Many analysts now view it as the perfect value stock for 2023.
Which is right for you?
There is no rule that says you can't own both growth stocks and value stocks. Both have their own advantages and qualities. Diversified exposure to both will give you the best of both worlds.
It’s also okay if you prefer one investing style over the other. As far as IQ is concerned, we aim for a smart blend of both styles in our portfolios. We have confidence in the fund managers with whom we invest to focus their attention on the long term, rather than trying to time the market in favour of one over the other. Once you have a clear idea in your mind of your financial roadmap and your own personal goals, you’ll have more of a sense of whether a growth or value approach – or a subtle blend of the two – is what you need.
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