Newcomers to investing in stocks may be perplexed by the classification of stocks and funds as either “growth” or “value.” Stock market investing can seem overwhelming with large-cap versus mid- or small-cap stocks, and now there’s this: another breakdown into another set of classifications. What is an investor to do?
It doesn’t need to be overly complicated. Investors into growth or value are seeking the same thing — appreciation of their investment. They are just going about it in a different way.
Stocks can be classified as a growth investment based on having above-average gains in earnings or the potential for above-average gains in earnings. An above-average gain in earnings is indicative of above-average growth; a growth investor believes the share price will follow the earnings growth.
Outperformance, from an earnings standpoint, could be as compared to a broad measure, such as outperform versus the overall market, or a narrower measure, such as outperform versus their industry peers, or segment.
Above-average earnings growth can be fueled by superior product or by superior execution, with the latter often being titled superior management.
Growth stocks can be small-, medium-, or large-cap companies. They tend to reinvest their earnings into growing the business, and are not likely to pay dividends to their shareholders. They tend to trade at relatively high price/earnings ratios.
Growth investments tend to outperform during bull markets and tend to be more volatile than their value peers.
A mutual fund or exchange-traded fund (ETF) can be classified as a growth investment based on its underlying investments; a growth fund will hold primarily growth stocks.
Stocks can be classified as a value investment based on trading for less than its worth according to one or more metrics. For example, a stock may trade for less than its book value or at a relatively low price/earnings ratio, as compared to the broader market or as compared to its market segment and be considered a value investment.
Undervaluation can happen for a variety of reasons. Stock prices are perception-driven; investors drive stock prices up or down based on overall sentiment. A stock can fall out of favor with investors if they feel the company’s products are not keeping up with trends or for a myriad other reasons.
A company that is undervalued may have a good opportunity for future price appreciation, if the underlying financial health is sound and the company is competently managed.
Though value stocks can be found in small-, medium-, and large-cap companies, value tends to be more concentrated at the large-cap end of the spectrum, with larger, more established companies and industries.
Value stocks are more likely to be dividend payers, as opposed to their growth peers. Value stocks also tend to be less volatile; their prices are more stable across shorter time periods, as compared to growth stocks.
A mutual fund or ETF can be classified as value if it holds primarily value investments.
If we look at growth and value as points on a business cycle timeline, we would see that any company could conceivably be a growth company or a value company depending on where it is in its lifecycle. Newer companies, such as most tech companies, will tend to be growth companies.
More established companies could be either growth or value, depending on how they are performing relative to their peers and the market in general. A company that is a growth company may be a value company five years from now, and vice versa.
A company can be in between those two distinct categorizations, a hybrid or blend of both growth and value. Blend companies have characteristics of both growth and value stocks but not favor one over the other.
The styles of growth and value stocks tend to perform out of sync — in any given year, one will lead or lag the other. Because markets cannot be predicted in advance, many investors will allocate their stock holding between growth and value, a solid conservative approach recommended by many investment professionals.
Across time, two things can happen: One category may outperform the other, necessitating rebalancing to maintain your desired allocation. Additionally, some holdings, for individual securities, may transition from growth to value or hybrid, and vice versa. Again, this change would be cause for rebalancing.
A diversified stock portfolio will take advantage of not only the differences of market capitalization, holding small-, mid-, and large-cap stocks, but will also hold both value and growth stocks, perhaps in each category, depending on the overall stock allocation.
Many smaller investors take advantage of either mutual funds or ETFs to allocate their holdings into their desired categories and be able to do so in the dollar increments they desire.
The Bottom Line
For investors, the end goal remains the same: Having your money grow at a rate greater than the rate of inflation, thereby increasing your purchasing power across time.
Both growth and value stock investing strategies have been used successfully to do that. Both have had periods where they performed better than the other category; both have also had periods where they underperformed.
For many investors, an approach that includes a combination of both growth and value stocks across the three size categories of small-, medium-, and large-cap will provide greater diversification and reduce downside risk as compared to a narrower allocation into one category.