The great debate: How growth vs. value stocks differ and why each could be worth owning
Growth versus value: It’s the ultimate argument among stock investors, and over long time periods, they duke it out for market dominance.
Those in the growth stock camp happily pay up for stocks with low but fast-growing earnings, with the expectation that earnings will accelerate in the years to come. Investors who tout value stocks seek overlooked and undervalued bargains and solid, reliable cash cows.
Key Points
- Growth versus value pits fast-growing stocks with big potential against solid performers that grow more slowly.
- Growth stocks can be attractive for investors with long time horizons, while value stocks often provide dividend income.
- A portfolio can have both growth and value stocks and potentially benefit from the ebbs and flows.
Investors sometimes think of growth-versus-value as an either/or proposition. Some might identify themselves as one or the other. But diversified portfolios often mix and match value with growth to potentially benefit from each, because one often outperforms the other for a while before the equation flips the other way. Some investors jump between growth and value when they think the wind is blowing in the right direction for one over the other.
Growth and value stocks have different characteristics, including performance histories and future expectations.
What’s a growth stock?
Growth stock characteristics include:
- High price-to-earnings (P/E) ratio. This ratio tells you if a stock is trading at a premium or discount in relation to its earnings. A fast-growing stock could trade at a high P/E ratio compared to its competitors, especially if revenue and earnings are growing at a quick pace. Investors often happily “pay up” for a stock if there’s the promise of sizzling future growth.
- Position in a fast-growing market. Parts of the market associated with growth can vary over the years. In the 1960s, a group of leading growth stocks called the “Nifty Fifty” included companies such as IBM (IBM), McDonald’s (MCD), Coca-Cola (KO), and Texas Instruments (TXN). Today, most Nifty Fifty names are what many consider value stocks, while big growth areas tend to be sectors like semiconductors, cloud computing, and biotechnology.
- Robust earnings growth. Growth companies often sport earnings and revenue growth that’s off the charts compared to more humdrum names in the market. Often, this means quarter after quarter of double-digit revenue and earnings gains. You also often see a high free cash flow (a good indication of the strength of a company’s profits).
- Strong guidance and the ability to exceed guidance. Many companies deliver “guidance” each quarter, telling investors how much they expect to earn in coming months. A company that can exceed guidance often gets a reputation as a growth company, especially if earnings grow faster than competing companies. Exceeding guidance gives investors confidence that the company can maintain its firm growth, often leading to a higher stock price.
- Volatility. Growth stocks tend to be more volatile than value stocks, meaning prices fluctuate a lot. Growth companies must constantly show progress in capturing new customers and markets. When they don’t, they tend to get punished by the market. Growth investors can lose money quickly, especially when a recession hits.
What’s a value stock?
Here are some characteristics of value stocks:
- Low P/E and P/B ratios. Value stocks tend to have lower P/E and P/B (price-to-book) ratios than their competitors. There are lots of reasons for low ratios, and not all of them good from a value investing perspective. A low ratio can mean a history of disappointing earnings performance, poor leadership, or lack of exciting products. Sometimes, though, a low ratio can indicate a “gem in the rough,” meaning a high-quality stock with growth potential that’s been overlooked by most investors.
- Position in a “value” sector. Some market sectors are often associated with “value,” though this can ebb and flow. Typically, the more cyclical sectors (those most exposed to the ebbs and flows of the broader economy) tend to hold value names. When you think of cyclical areas, sectors such as materials, industrials, and energy often come to mind, though value stocks can be found in every sector.
- Generous dividends. Many companies whose stocks are in the doldrums try to attract investors with dividends (cash or stock payments paid out of profits to investors). Sometimes this can clue you in about an undervalued stock, especially if the company has been steadily paying dividends for years. Remember, however, that dividends can fall or disappear, often the sign of problems.
Measuring growth vs. value performance
It’s difficult to measure exact performance over time for growth versus value, in part because many analysts use different metrics. One way is to compare indices. For instance, FTSE Russell has a Russell 1000 Growth Index and a Russell 1000 Value Index. Although each index has experienced periods of outperformance and underperformance, growth really took off in the mid-2010s. See chart below.
However, much of the performance discrepancy between growth and value came from varying sector weights within the indices. Technology—a sector heavily represented in growth indices—enjoyed an explosive rally through much of the decade from 2010 to 2020. Technology stocks benefited not just from company innovation and growing demand, but also from historically low interest rates.
Soft rates kept borrowing costs low for growing tech companies, helping make their future earnings potential look very strong (lower costs help profit margins). That kind of outlook tends to favor growth, and gets back to the idea that investors pay up for stocks they believe offer vigorous future earnings power.
When growth becomes value and vice versa
Just because a stock is considered “value” today doesn’t mean it’s always going to be. Same with growth. A value stock that’s suddenly embraced by many analysts and investors can soon trade at a P/E multiple that no longer makes it a bargain.
Those Nifty Fifty stocks were once the biggest growth names in the market, but that was 40 years ago or more. Now some of those growth stocks behave more like value stocks, often paying big dividends and trading at lower P/E ratios.
The bottom line
Growth versus value stocks both have their allure. A value stock can come cheap, but then be like an ugly duckling that suddenly grows some colorful feathers. A growth stock can provide quarter after quarter of earnings success, but at a price.
Many financial experts suggest that investors sprinkle both growth and value into their portfolios to take advantage of market ebbs and flows. Growth stocks tend to do great when the economy is humming along, but value stocks can be less volatile and not fall as far when recession hits.
So, how do you settle the age-old argument? It’s a draw. Value and growth stocks have a place in balanced portfolios.