There’s no “right” or “correct” way to invest. Your objectives, needs, and personally defined level of acceptable risk all inform individual investment strategies.
Value investing and growth investing are two popular strategies for identifying stocks with the potential to provide positive returns. Value investing focuses on finding undervalued, generally mature, and stable companies. On the other hand, growth investing focuses on young enterprises with the potential to grow at an especially fast rate.
Both types of investments play a valuable role in most portfolios, but they may not live up to their hype as investment strategies. Ultimately, your personal goals and risk thresholds should determine what mix of both will work best for you. Keep reading to learn more about value investing and growth investing.
Key Takeaways
- Value investing involves buying stocks that appear undervalued based on financial metrics like dividend yield and P/E ratios. These stocks typically belong to mature companies. Growth investing targets companies with strong potential for future growth, often reinvesting profits for expansion.
- Historical data indicates that value stocks have provided stable long-term returns and outperformed growth stocks in certain periods. In contrast, growth stocks have shown potential for higher short-term returns but with more volatility and risks.
- Diversifying investment portfolios by combining growth and value stocks can optimize returns across different market conditions. Investors can execute these strategies using mutual funds, ETFs, or individual stock picks based on their goals and risk tolerance.
Understanding Value and Growth Investing
In investing, “value” and “growth” are two terms that often come up as distinct styles. The debate between value and growth investing is as old as investing itself, with each investment style having its legion of loyal followers who swear by its merits. But what exactly do these terms mean?
Analysts deem value stocks undervalued based on their intrinsic value, while companies with robust future growth prospects make up growth stocks. It’s worth noting that some stocks can straddle both categories, qualifying as both value and growth in mutual funds due to varying selection criteria.
Defining Value Stocks
When we speak of value stocks, we’re referring to stocks that may be undervalued based on specific financial metrics. These metrics include a high dividend yield, a low price-to-book ratio, or a low price-to-earnings ratio. These metrics indicate that these stocks are trading at a stock price lower than their intrinsic value, as suggested by their financial metrics like net income, dividends, and book value.
Value stocks often belong to mature companies with strong underlying fundamentals, but they might not be getting the recognition they deserve in the market. This could be due to recent adverse events or simply because the market underappreciates them.
Defining Growth Stocks
On the other hand, we have growth stocks. These are equities of companies with strong anticipated growth potential. A growth stock tends to be found in sectors like technology, healthcare, or emerging markets. Their characteristic feature is their potential to outperform the market due to their future growth prospects, often exhibiting rapid revenue and earnings growth.
However, a distinguishing characteristic of a growth stock is its tendency to reinvest profits for additional growth rather than to pay them out as dividends, as is typically the case with a value stock.
This is why growth investors evaluate and define stocks using metrics like the price-to-earnings (P/E) ratio, the price-to-book (P/B) ratio, and the price-to-sales (P/S) ratio. Higher ratios tend to suggest growth, while lower tend to suggest value. But this is not an absolute rule. High P/E ratios can sometimes indicate overvaluation in the stock price generated by irrational excitement in the market, and low P/E ratios can sometimes mean the company just isn’t doing well.
Historical Performance: Growth Stocks vs Value Stocks
Now that we understand the basic concepts of value and growth stocks let’s look at the historical record for additional insights. As we do this, we must remember that the time period matters. In any given year, growth stocks might outperform value stocks; in other years, value stocks do better. The same can be true for longer periods of time, sometimes stretching 10 years or more. In the last 30 years or so, there have been a couple of 6-10 year stretches of past performance that have favored growth, a couple that have favored value, and lots of individual years when one type was better than the other.
Often, when one type of stock has performed better than the other, the underperforming stock will stage a remarkable and sudden recovery. For example, in 2022, growth stocks peaked. However, after a stretch that favored growth stocks, value beat growth that year by roughly 26%.
As is often the case, one industry sector within the category can dominate the performance of growth or value stocks. Growth stocks typically include companies in technology, including concentrations like “the Magnificent Seven,” which refer to the following companies:
- Apple
- Microsoft
- NVIDIA
- Alphabet
- Amazon
- Tesla
When they did well, stock prices in the growth category exploded. But we should all remember the dot-com crash of 2000. Technology stocks had performed very well for investors for an extended period of time, but changes in the economy and interest rates combined to decimate their performance in 2000. This industry sector took 15 years to return to its previous peak.
Long-Term Trends
Because of these long sweeps of time when one style performs better than the other, we often hear, “Growth investing is better than the value approach,” or the opposite, “Value investing has outperformed growth.” The truth depends on the time period we choose to make that calculation. And even if we know what the past 7, 10, or even 20 years have produced, there is no guarantee that the future 7, 10, or 20 will be the same.
This is the danger of making generalizations or predictions based on history. If the history is too short, the conclusions are absolutely worthless. So, it may be true that in the last X years, one style has beaten the other, but when we look at very long periods – say 20+ year periods – we find that value and growth stocks tend to generate very similar average returns.
In fact, in one relatively recent 40-year period, both growth and value strategies returned nearly identical average returns. This reality is both fascinating and actionable. It’s actionable because it tells us to be very cautious about making stock decisions based on history that may seem long in human terms but, in reality, are inconclusive in market terms.
Recent Developments
As we’ve hinted above, recent developments significantly influence the performance of value and growth stocks. Whatever the moment’s trend is – value or growth is up – the economy, government policy, interest rates, etc., are constantly changing. These changes always affect markets and both growth and value stocks. Those effects can be small, and we typically don’t notice them, or they can be significant and almost instantly change the comparison of value vs growth investing.
Pros and Cons of Value and Growth Investing
Now that we have a solid understanding of value and growth investing and the dangers of relying on an improper understanding of historical performance, we can explore the advantages and disadvantages of both types of investment strategies. This will help you make informed decisions about how to use each to align your investment goals and risk tolerance.
Benefits of Value Investing
One of the most attractive features of value investing is that if done correctly, you’re buying stocks at a price that is less than their real value. Another advantage to value stocks is the probability that they will pay steadier dividends than growth companies, and dividends provide concrete proof of profitability. Growth companies cannot afford to pay dividends if they don’t have profits in the first place.
As trustworthy as American accounting standards are, there are still many areas where “profits” are impacted by non-recurring items. In such cases, profits this year may not be indicative of profits next year. When a company’s management decides to pay dividends to the stockholders, it signals a high confidence level that profitability is sustainable.
Drawbacks of Value Investing
On the other hand, there are significant drawbacks to value investing. Chief among these is that it is not easy to practice value investing correctly. As noted above, the financial metrics that are hallmarks of a “value” stock may actually be signs of weakness. Because value stocks tend to represent older companies, which are more mature in their industry niche, there is a genuine danger that they have passed their prime and will be eclipsed by a younger company disrupting their industry.
Classic examples of companies that supposedly owned their industries and subsequently fell include Sears, Pan Am Airways, Kodak, Polaroid, and Borders, to name a few. Successful value investing demands a thorough understanding of what drives the financial metrics that indicate a stock is a good value purchase. To truly identify undervalued stocks, value investors need to:
- Delve deep into a company's financials
- Analyze its competitive position and industry trends
- Assess its management team and corporate governance practices
It may take years for the market to adjust a stock price to its perceived true value, which can test an investor’s patience and conviction in the stock’s value.
Advantages of Growth Investing
Alternatively, growth investing presents its unique benefits. Growth stocks are typically those of companies with the potential for above-average returns because they are growing in their industries. Growth companies are doing something better than the competition, and customers buy from them.
The primary advantage, therefore, is that growth stocks offer the opportunity for higher-than-average returns. Secondary to that is the benefit of aligning yourself with the future. Many growth companies are reinventing their industry sector, developing better ways to produce and sell a product, or even introducing new cutting-edge products that didn’t exist before.
Growth Companies often:
- Develop innovative products, services, or business models
- Capitalize on secular trends and evolving consumer behaviors due to technological advancements
- Excel during bull markets or periods of global economic growth, demonstrating strong performance in favorable economic conditions and outpacing the broader market
Disadvantages of Growth Investing
Despite their high-return potential, growth stocks represent significant risks. These risks include:
- High volatility
- Susceptibility to market corrections and crashes when growth expectations are not met
- Outright failure because the new product or service isn't accepted by the customer or can't be sustained profitably
Furthermore, overvaluation – paying too much for the stock price – tends to be more likely with growth stocks than value stocks. Growth stocks can trade at high price-to-earnings ratios based on an irrational belief that rapid future growth will justify such valuations. If these stocks fail to meet those market expectations, the high valuations can crater and cause significant losses for investors.
Diversification: Combining Value and Growth Strategies
You may have heard that “diversification is the only free lunch,” and it’s true. The odds of successfully beating a broad market by focusing on growth investing alone or on value investing alone are very small. But if you find the right blend of value and growth stocks, you can significantly decrease the risk in your investment portfolio.
This is because these two styles often perform well at different times under different market conditions. So when growth is up, value may be down. But there will inevitably be times when value is up and growth is down.
Instead of staking your future on picking when one style will outperform the other (known as market timing), combining growth and value stocks in the right mix provides both the value investor and growth investor with the best of both worlds. You can harness the benefits of both investment styles while reducing overall risk.
Using both growth and value stocks in the equity portion of your portfolio can potentially yield returns when either style is in favor.
A blended investment approach pursuing both value and growth stocks will almost always outperform a portfolio that tries to time these segments by switching between them.
Portfolio Allocation
Allocating your portfolio to both growth and value stocks is the right approach, but there is no one-size-fits-all allocation for everyone. The right allocation mix is tailored to your own investment strategy, goals, and risk tolerance. One investor may need to favor growth, while another investor may need to favor value, but both these investors should have growth and value stocks in their portfolios.
Rebalancing and Market Cycles
The second part of this type of investment allocation approach is rebalancing. It is often overlooked but vital in generating the benefits described above. As markets fluctuate, you need to periodically adjust the weight of growth stocks and value stocks in your portfolio to maintain your selected allocation mix. This rebalancing process can be done monthly or quarterly; at the very least, it must be done annually. You cannot just buy growth and value stocks with a “set and forget” mentality. You must rebalance to enjoy the benefits of asset allocation.
Investment Vehicles: Mutual Funds, ETFs, and Individual Stocks
The inevitable question at this point is what type of growth or value stocks you should use. Should you buy individual stocks, mutual funds, or ETFs? Each of these options will give you the needed exposure to value and growth stocks. Among them, we believe there is one clear loser. Do not try to pick individual stocks.
The investment world is full of professional growth investors and value investors who buy and sell individual stocks every day. If you enter this competitive market, you are stacking the odds against you. Trying to beat the professional portfolio manager is a fool’s errand.
Fortunately, mutual funds and ETFs provide a successful means to enjoy the benefits of growth and value stocks without competing against the professionals. Professional investors manage mutual funds and ETFs. When you purchase a growth mutual fund or value mutual fund, you are effectively giving your money to the professional who manages that fund and allowing them to make the professional decision of which stocks to own, when, and for how long.
For the purposes of this article, the difference between mutual funds and ETFs is essentially a matter of how much you have to invest and, therefore, how best to diversify that amount of money. There are very good ETFs and mutual funds, but they have different minimum purchase requirements and internal costs.
The Key to Successful Investing
In conclusion, you should not try to figure out whether growth investing or value investing is best. There really is no absolute answer. Both offer significant advantages, but combined, you get to enjoy the benefits of both of them.
The key to successful investing is determining what combination – your asset allocation – between value vs growth best meets your portfolio’s goals and your risk tolerance. We highly recommend working with a 100% objective investment advisor to design this allocation for you. The right allocation mix will serve you well. If done poorly or by an amateur, you’ll likely fall behind your investment goals and experience more risk and volatility than you can handle.
Once you set your allocation mix, that same objective advisor can help pick the right funds or ETFs to efficiently implement this strategy and then maintain it going forward. Remember, you can’t just set and forget. An objective advisor will ensure that the portfolio is reviewed regularly and that it is rebalanced appropriately.
At First Financial Consulting, we have worked with clients for 40+ years, providing 100% objective investment advice and management. We do not sell stocks, mutual funds, or ETFs, and we do not accept commissions that taint our objectivity. We work with our clients to find the right mix of funds and ETFs to ultimately help them achieve their financial goals.
The right investment strategy for you implemented consistently over time, will significantly improve your financial future. And the right strategy is different for every investor. Don’t settle for off-the-shelf strategies and cheap one-size-fits-all recommendations.
No matter your life stage, now is the time to do the work and develop a personalized strategy and plan. If you’d like to discuss your needs and explore how First Financial can help you achieve your dreams, we’d love to begin that dialogue. Click the button below to start the conversation.
Greg Welborn is a Principal at First Financial Consulting. He has more than 35 years’ experience in providing 100% objective advice, always focusing on the client’s best interests.
Greg Welborn is a Principal at First Financial Consulting. He has more than 35 years’ experience in providing 100% objective advice, always focusing on the client’s best interests.
