Growth Vs. Value: Identifying the Right Investment Approach For You
Understand the difference between growth vs. value stocks to determine which investment style aligns with your goals.
By Charlene Rhinehart | Black Enterprise
6 Min Read | October 1, 2021 in Money
Growth companies are expected to produce above-average returns and outperform their peers because of their distinctive advantages in the marketplace.
Value companies are believed to be bargain stocks that have the potential to produce a high return later when their true value is unlocked.
Determining whether a growth or value stock investing strategy is the best decision for you depends on a few key factors: personal goals, risk tolerance, and time horizon.
Investing in the stock market has been one of the simplest ways to build wealth and combat inflation over the long term. Since the S&P 500’s inception, data indicates there has not been a 25-year period when it delivered a negative return. Although past performance does not guarantee future success, the stock market has shown itself to be an ideal place for investors to park extra cash and maximize long-term wealth potential.
Investors who want to leverage opportunities in the stock market should focus on identifying the right investment approach for their portfolio instead of trying to find the perfect time to invest. Despite the initial market sell-off during the beginning of the COVID-19 crisis, the S&P 500 went on to produce an outstanding 18.4% total return for 2020, and it has exhibited a strong performance for 2021 thus far – 14.07%.1
Although the stock market is susceptible to uncertainty and turbulence, investors can still realize great long-term gains. But a perennial debate is still in session: Will investors focused on value or those bullish on growth fare better in the long term?
Let’s explore the differences between growth and value investing. Then we’ll provide important considerations to help you make appropriate decisions for your portfolio.
The definition of a growth investment can be summed up in two words: extraordinary potential. Growth investors seek to buy companies that have the potential to go above and beyond the average performance of the market and produce strong earnings and share price performance. These companies are on a mission to transition from starter businesses to market leaders as quickly as possible.
Characteristics of growth stocks include:
- Growing consumer base.
- Competitive industry advantage.
- Low or no dividend payouts.
- Wild price swings.
- Higher-than-average price-to-earnings (P/E) ratio.
Since growth companies focus on rapid market results, they reinvest money back into the company, giving shareholders a chance to benefit from capital appreciation when they sell their shares in the future.
Paying a premium price for growth. There’s typically a higher price to pay for companies that fall into the growth bucket. Growth stocks tend to be pricier than average stock as measured by valuation metrics like price-to-earnings or price-to-book value ratios. However, those who flock toward growth investments view the earnings potential as well worth every dime they’re paying for the stock today. In the future, investors expect to see faster revenue growth in comparison to peers in the industry.
If you’re looking for growth stocks to add to your portfolio, you’ll typically find them in industries that are growing fast and in spaces that are ripe for disruption. Technology and biotech are two common growth sectors. Many of these stocks are listed on the NASDAQ exchange.
While growth investors are on the hunt for booming stocks that have the potential to produce exponential returns, value investors are seeking to find treasures that are currently overlooked in the marketplace. Value stocks may be temporarily beaten down due to public relations scandals or unfavorable conditions within their industries.
Characteristics of value stocks include:
- Predictable cash flow.
- Steady business model.
- Regular dividends payouts.
- Low P/E ratio.
Investors may get an added level of assurance with value stocks because they have already proved their worth. The companies typically have steady, predictable business models that give investors hope for the future.
Although the earnings and growth may be modest for value stocks, investors who are seeking a reliable source of income in the form of monthly or quarterly dividends find value stocks very appealing. Some value stocks help investors achieve the best of both worlds: capital appreciation plus income.
A deal in the stock market. Value stocks are considered bargains that have the potential to make a strong comeback. It’s an attractive deal for investors who want to grab stocks at a low price. These stocks are trading below what they are currently worth in the marketplace, providing an opportunity for investors to scoop up potential gains that others may be overlooking.
Value stocks have relatively cheap valuations based on metrics like P/E ratios and long-term growth prospects. Once the company rebounds, value investors expect to see the stock price rise as more investors understand its true value.
Both growth and value stocks have many benefits, but they each come with their own risks. When investors put their money into growth stocks, there’s a risk that the company may not grow as expected. When it comes to value stocks, there’s a risk that the company’s setback is longer than expected and dividends are cut or suspended. When investing your money in the stock market, it’s important to examine historical performance and trends to manage expectations.
Growth stocks have a record of performing better than value stocks when market conditions are good. The past decade represented the longest-running bull market in American history, paving the way for technology and growth names to soar and dominate the markets. Growth investors are attracted to the Russell 2000 Small Company Stock Index to find companies that will display significant growth relative to the market. This represents an opportunity for growth-minded investors to become students of the market.
When you look at historical data over a longer time horizon, value stocks have delivered greater returns for investors. These companies are typically in more mature industries. Value investing has materially outperformed growth investing since 1926, showing a gain of 1,344,600% versus growth’s return of 626,600% over that same almost 100-year period.
Looking only at 2020, growth stocks were the clear winner. The surge in tech stocks widened the spread between growth and value stocks. Although growth stocks have been leading the way in recent history, the tide could possibly turn in favor of value stocks as we enter a new era.
As a student of the market, it’s important to pay attention to both growth and value cycles. Since no one can predict the future with absolute certainty, understanding historical performance can help you make more informed decisions.
Growth stocks and value stocks represent two fundamentally different approaches to stock investing that can offer lucrative opportunities to their followers. Deciding between the two approaches can be difficult if you’re just starting your investment journey. The first step you can take is to identify your goals and measure your risk tolerance. When you understand what you want and the potential loss you are willing to endure, every other decision on your investment journey becomes a bit easier.
Here are some factors to consider when determining the best investment strategy for you.
Risk tolerance. It’s important to understand risk tolerance before making an investment decision. When people think about risk, they immediately think about loss. But it’s more beneficial to think about risk as the degree of uncertainty you are willing to overcome (through education and research) to achieve potentially greater returns. A main reason so many investors miss out on great returns has been discomfort with volatility. As a rule of thumb, value stocks, determined by their intrinsic value, tend to be less risky than growth stocks, which focus on the anticipated outperformance of the overall market.
Time horizon. Look at how individual investors develop their portfolios for long-term returns vs. market timing with “hot stocks.” A person’s age should be taken into consideration. Determine when you will need the money.
Personal goals. Are you seeking current income from your portfolio? If so, you may want to explore value stocks. Most growth stocks don’t pay dividends because they prioritize future growth potential by reinvesting profits back into the business to generate more growth. Do you want stable, predictable growth? Are you willing to trade in comfort for extreme growth? When will you need a return on your investment? These are all questions to consider when developing your personal goals.
Diversification. Although many investors favor one investing approach over the other, it’s important to realize that both value and growth stocks can play a strategic role in a portfolio. You don’t have to choose one or the other. You can create an investment strategy that captures the benefits of both strategies. For example, investors can look into “growth at a reasonable price” (GARP) to unlock a combination of value and growth investing.
For new investors, there’s an opportunity to pursue these different styles of investing through mutual funds or exchange traded funds (ETFs). Both of these offer a way to purchase a basket of equities that focus on growth or value funds.
There are pros and cons to both value and growth investment. But they both give you access to one of the greatest wealth-building opportunities of our time: the stock market. Understanding how both investment strategies can play a role in your portfolio can allow you to maximize the benefits of being an investor.