Understanding Growth And Value Investing

 

Knowing how to invest is the best way to build wealth. There are many ways to make or lose money in the stock market. Here, we will focus on growth and value investing. They differ in their fundamental investment approaches and valuation. 

You can purchase growth and value stocks individually or through mutual funds or exchange-traded funds (ETFs). Each has its disciples who support their respective strategies. To pick what works best, consider your investment goals, risk tolerance, and time frame. Whatever you do, make sure to diversify your portfolio.

Which Is Better: Growth Vs. Value Investing?

One question often raised, which is better to invest in, growth stocks or value stocks? There isn’t one answer. Growth stocks have visibly outperformed during the pandemic and can be more resilient during economic downturns than value stocks. Over the past decade, experienced investors will point to growth stocks as the better performers during the longest bull market. That is true.

However, value stocks have led the market after significant bubbles, notably the post-dotcom crash in the early 2000s. Some believe growth stocks look like a bubble now.

Many studies point out when value stocks outperformed growth stocks. According to work done by Research Affiliates in California, a portfolio consisting of value companies beat a portfolio of growth companies by a wide margin over a long time horizon.

From July 1963 to December 2006, the value portfolio outperformed nearly ten times. Then from January 2007 through September 2019,  the value portfolio has underperformed by 36%. Rotations happen.

Despite Strong Growth Stock Performance, Value Stocks Have Not Lost Their Vigor

Research by Dimensional Fund Advisors compared long-term averages for growth and value stocks. They found that growth stocks grew 14.7% during the past ten years, compared to 11.3% since January 1979.  On the other hand, value stocks rose 11.4% in the past ten years, in contrast to 11.9% since January 1979.

While the growth fund grew 3.4% in recent years, value funds have mostly tracked their historical average. It is easy to say that value stocks are out of favor, but this study states a misconception given value stocks’ steady performance.

Blended funds are appealing as they contain a mix of growth and value stocks available in one fund. Given the difficulty of pegging one investment style over the other, blended funds offer diversification and access to stocks of both approaches.

 

Characteristics of Growth Investing

 

“The number one market leader is not the largest company or the one with the most recognized brand; it’s the one with the best quarterly and annual earnings growth, return  on equity, profit margins, sales growth, and price action.”

William O’Neil

 The Positives

Growth stocks appeal to long-term investors who seek higher growth companies. The companies they represent are often leaders in the markets they serve. These stocks recognize the high-risk, high-reward nature of this investing approach. Buyers of these stocks seek companies that promise consistent high top and bottom-line growth in all economic conditions.

These stocks tend to have better than average growth in the company’s revenues, cash flow, and earnings compared to the broad market. Growth companies usually reinvest their profits and capital resources in their business to fuel future expansion rather than pay dividends. 

In contrast, emerging growth companies may generate losses longer. As a result, they may need to raise capital to make long-term investments during their early growth stages.

Amazon, A Prime Example Of A Growth Stock

Amazon is an excellent example of a successful company dominant in all of its businesses. As the largest global online retailer, Amazon has rapidly invested heavily in fast-growing businesses, notably subscription, cloud computing products, advertising, grocery, and healthcare. This growth company would rather keep its foot on the accelerator than pay dividends to shareholders and will not do so any time soon.

Growth stocks typically sport higher valuations on price-to-earnings, price-to-sales, and price-to-book value than the S&P 500 valuation. The calculation of a company’s book value is the value of all the assets less its liabilities.  Typically, book value is different than a company’s market value or capitalization.

Market capitalizations or market caps for publicly traded companies is the current price per share multiplied by its outstanding shares. Growth stock values are usually higher than their book value. In contrast, value investors seek stocks trading at discounts to their book value.

Stocks of growth companies can range from small caps to more developed large-cap companies. The smaller companies are at an earlier stage than their large-cap brethren, and as a result, more volatile. They face more significant risks but also provide greater returns to investors.

Origins of Growth Investing

Thomas Rowe Price, )founder of T. Rowe Price) is known as “the father of growth investing.” As an early promoter of growth stocks, he believed that investors could earn superior returns by investing in well-managed companies.

The growth expectations for earnings and dividends were to outpace inflation and the economy over the long term. The key was finding companies in their early stages when they were considered emerging growth companies.

In its heyday, Peter Lynch, lead portfolio manager of Fidelity Magellan Fund, refined growth investing by popularizing the PEG ratio. This ratio tracks finding growth at a reasonable price. It divides the price/earnings ratio by the company’s growth rate.

A PEG ratio of 1 means that the stock is reasonably valued, and investors need to look for multiples below that level. This concept relates a stock’s price/earnings ratio to its growth level: the lower the PEG, the more attractive the shares.

Benchmarks For Growth Stocks

1. Companies have high revenue and earnings growth with a visible track record. In essence, investors anticipate that earnings growth will be forthcoming sometime in the foreseeable future. However, in recent years, investors have been willing to forego earnings growth in the near term as revenues ramp up at healthy levels.
2. Along with top-line growth, investors like to see the expansion of gross, operating, and net margins. Over time, the sustainability of those margins becomes critical as companies become more mature.
3. Growth stocks are companies that have competitive advantages. These competitive advantages allow them to become dominant in growing markets with excellent prospects. Morningstar often refers to good companies as having economic moats like a low-cost structure, tough to switch to another provider or a loyal customer base. These attributes protect those companies from advancing competitive threats. Think of Apple, and its iPhone users devoted but don’t want to move to another smartphone.
4. Investors in growth stocks are long-term investors seeking higher returns and are usually risk-tolerant. Growth stocks tend to do better than value stocks in weak economies.

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The Negatives

Above-average valuations often price growth stocks for perfection. That means the company results that meet or miss expectations disappoint investors. As such, investors will more quickly dispose of their shares at any troubling signs.

Growth shares tend to be volatile and can be micro-cap and mid-cap companies early in their development. The beta index is a popular measure of volatility. It accounts for market fluctuations of a stock and how it varies from the rest of the market. A beta value of 1 or lower indicates relatively safe security. On the other hand, growth stocks tend to have betas of 1.5 or more.

Companies tend to pay low or no dividends, preferring to reinvest profits into their growing businesses.

Growth Funds and ETFs

Given their volatile, high-risk nature, an excellent way to invest in growth stocks is through growth mutual funds or ETFs. You can buy a basket of stocks in a range of market caps, from large caps to small caps. Two examples are the Vanguard Growth Index (VIGAX) or Fidelity Growth (FDGRX).  Here are Morningstar’s Best Growth Funds and the best Exchange-traded funds (ETFs). While the tech sector is growth-oriented, you may want to research the many subsectors within that category. Beyond pure tech, other sectors to consider: health care, online retail, and fintech.

Characteristics of Value Investing

 

“The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes stocks too cheap). The Intelligent Investor is a realist who sells to optimists and buys from pessimists.”

Benjamin Graham

 The Positives

As a counterpart to growth stocks, value stocks appeal to investors seeking well-managed good companies that pay dividends. A higher dividend yield helps value investors to be patient while waiting for the company to turn around. They are typically less risky and attractively priced below that of their peers and the broad market average.  These are “diamond in the rough” stocks.

 Investors will look for a potential bounce in these undervalued stocks to believe that the market isn’t always efficient.  Value creation comes from an apparent gap between what a stock is trading at and its intrinsic worth.

Hence, it may call attention to a hidden gem manufactured when the company experienced a temporary setback. Problems may arise from disappointing earnings, lackluster product rollout, management departure, or an overhang on the stock due to a legal or regulatory problem. Value investors will try to spot short-term issues. 

Bargain Valuations That Are Unwarranted

Cyclical stocks are considered value stocks that do better in the early stages of an economic recovery but lag in sustained bull markets. Unlike growth counterparts, value stocks are less volatile (lower betas) and usually supported by healthy dividend yields. These income streams can benefit investors as they await the potential of these stocks.

Value investors look for bargains in the market that may be unwarranted. A deal is when the stock’s market value is trading below the company’s intrinsic or fundamental value of its businesses.

Look for attractive valuations for these stocks with above-average dividend yields, low price/sales, and low price/earnings ratios. These cheap valuations are in contrast to the high valuations of their growth counterparts.

Several examples of companies–Apple, GE, Microsoft, and IBM, whose stocks were once growth stocks then fundamentally shifted into value stocks. In particular, Apple and Microsoft have reversed again in recent years and are now part of growth portfolios.  IBM may also be making a comeback to growing more quickly and leave the value nest soon.

The Origins of Value Investing

Benjamin Graham, who wrote The Intelligent Investor and Security Analysis with David Dodd, is often referred to as “the father of value investing.” I have well-worn copies of both of those books. Graham may be better known for mentoring Warren Buffett, one of his students at Columbia Business School.

Graham-Influenced Company Benchmarks

1. Investment-grade ratings use the S&P system with an earnings-to-price yield at least twice the AAA bond yield.
2. Pay dividends for the long term, yielding at least two-thirds of the AAA corporate bond yield.
3. Have a current ratio of 1.5 or better. This ratio is the current assets divided by current liabilities. Assets should more than cover liabilities for better liquidity.
4. Maintain low debt loads where long-term debt should be below current assets.
5. Total debt should be less than the book value of the company.
6. Positive earnings per share growth with no losses reported by the company in the past several years. Annual earnings growth of the prior decade of 7% annually.
7. Low relative valuations. The price-to-earnings ratio should be less than 40% of the highest PE ratio over the past five years. The stock price should be two-thirds of tangible book value, net of intangibles such as goodwill.

These guidelines, taken from Graham’s book, can provide value investors with some discipline. However, even Warren Buffett admits to underperforming the market when searching for value in a growth-oriented market. That said, he avoided chasing large acquisitions that were outside of his parameter, only acquiring Dominion Energy recently.

Value Stocks Need Positive Catalysts

Catalysts are good and bad triggers directly related to a company or its respective industry. All stocks, especially value stocks, need positive catalysts to bring rising investor attention to these hidden gems. Examples of financial news that may impact a stock positively or negatively are:

• Earnings report that disappointed, met, or exceeded revenues or other benchmarks;
• New forecasts for the company;
• Analysts raising or lowering estimates and price targets;
•  A new merger or acquisition announcement;
• Favorable product rollout and customer response;
• Management departure or new hire in a senior role; and
• Changes in regulation for the industry.

The Negatives

Finding value stocks requires hard work to determine what a company is worth. An analyst’s paradise to crunch numbers to analyze a particular stock and its peer group and compare it to its market value. It is essential to know what factors are overhanging the shares and whether they are short-term or long-term.

Patience is essential when investing in a value stock. Often, you may be fighting with the prevailing market sentiment that is viewing the name unfavorably. It can take months, if not years, for that sentiment to change. Sometimes an adverse event has happened to cause a stock to be “dead money.”

That slang refers to money invested in a security that has little or no chance of near-term appreciation. Fund managers and other institutional investors may race out of the stocks in the short term, worried about their near-term performance. For more Wall Street jargon, see our post here.

Value investing is less risky as you are already buying a stock at low P/E ratios. However, these stocks may not be as liquid as growth stocks.

Diversification is challenging to achieve as an individual investor. Value funds are probably a better way to go.

Value Mutual Funds And ETFs

The best way to achieve valuation when value investing is to find a mutual fund or an ETF. There are many value mutual funds and value ETFs ranging from small-medium and large caps.  You can find Morningstar’s Best Value Funds here.  A list of recommended Value ETFs is here.

 

Final Thoughts

Investing is the best means to build wealth. Growth and value investing are fundamentally different approaches to making money in the stock market. When investing, consider your investment goals, risk tolerance, and time frame.

Growth and value stocks appeal to different investors regarding risk/reward, volatility, valuation, and dividend payouts. Blended funds, which combine both types of stocks, can be an attractive alternative for the best diversification and exposure to both styles.

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