Growth investing and value investing are the two very different, yet common approaches to investing. The emergence of new disruptive companies in the last two decades has proved the importance of having exposure to growth stocks.
Meanwhile, the stock market crashes of 2000 and 2008 proved that value stocks can serve an important function in a diversified portfolio. In this post, we compare and contrast value vs. growth investing and discuss the pros and cons of the two stock picking strategies.
- What is growth investing?
- What is value investing?
- Key differences: Growth stocks vs. value stocks
- Examples of popular growth and value stocks
- Pros and cons of growth investing
- Pros and cons of value investing
- Which investment strategy is better: Growth or value?
- How growth and value investing can complement each other
What is growth investing?
Growth investing is a stock picking strategy focussed on companies that can grow and compound earnings quickly. Stock prices are a function of the earnings and expected future earnings of a company. If earnings grow rapidly over three to five years, a stock price that seemed expensive at the start can appear very cheap in hindsight. Stock prices appreciate rapidly when companies grow earnings at 25% or higher.
Growth investors focus on the aspects of a company that will allow it to increase earnings. Firstly, revenue is more likely to grow if the market is growing. Secondly, revenue will grow if the company is an industry leader and can increase its market share. Margins also affect a company’s ability to increase profits.
The ability to maintain or increase prices will improve margins, or at least keep them stable. If a company can reduce expenses, or grow expenses more slowly than revenue, margins will also improve. Growth stocks typically trade at a premium to the market. This is fine if the company can continue compounding its profits for long enough. However, if growth slows faster than anticipated, higher priced stocks will come under pressure.
Dividend investing is usually associated with mature, profitable companies. However, some growth companies do pay dividends, and their dividend yield can increase quite quickly. Dividend growth investing is all about finding companies that can increase their dividend yield enough to deliver a high yield on the original purchase price of the stock.
What is value investing?
Value investors buy stocks that they believe are trading below their intrinsic value. These stocks can go on to produce exceptional returns over the long term, as Warren Buffett has proved.
Buying stocks that are priced below their intrinsic value can give investors a margin of safety. When a stock is in favour and its stock price is rising, investors typically look to the future. This can result in severe corrections if it becomes apparent the stock price is discounting too much growth. On the other hand, if a stock is already trading at a discount, minor setbacks should not have a material effect on the stock price.
ESG investing and factor investing are two more modern approaches to investing that are closely tied to value investing. ESG investors consider the way environmental, social and governance issues affect the long-term value of a stock. Factor investing looks at fundamental factors that have been proven to result in outperformance of a stock over the long-term.
With value investing, when investors look for undervalued stocks, they will look at the value of the assets. Typically, they will look at the price to book ratio and the price to free-cash ratio. They will also consider the debt to equity ratio, the return on equity, and the ability of the company to pay dividends.
Key differences: Growth stocks vs. value stocks
Growth investing requires investors to find companies that are able to increase revenue and profits each year. These will typically be companies in new industries that have new and exciting products. Growth companies are most commonly found in the technology and consumer goods and services sectors. While the earnings growth rate ultimately determines the value of a company, growth investing often concerns the story that surrounds the company. Value may be determined by actual profits, but stock prices depend on expected profits.
Quality companies trade at discounts when they are shunned by investors, or the market overreacts to bad news. This can happen due to an unfavourable economic environment or company specific challenges. Value stocks are most commonly cyclical companies or companies that have fallen out of favour with investors. Very often they will be viewed as boring companies.
Just because a company is “cheap” it does not mean the price will recover. For a stock to be a good value investment, it needs to be trading at a discount to its assets, or at a discount to probable future profits. A company needs to be profitable or own assets with tangible value to make it a good value investment. Sometimes a reorganization or sale of assets is required to unlock value in a company. Value investors often consider turnaround situations and companies that are being restructured.
Examples of popular growth and value stocks
Examples of popular high growth stocks of the last two decades include Apple, Google, Amazon and Netflix. Apple and Google are examples of companies that grew both revenue and earnings. Amazon and Netflix have seen massive price appreciation on the back of revenue growth, despite being only marginally profitable. These stocks have both experienced several severe corrections due to their low margins.
Tesla is a good example of a stock that trades on sentiment rather than fundamentals. The result has been extreme volatility over the last few years. More recently hardware stocks like Nvidia and Broadcom, and software stocks like CRM and Shopify have been the standout growth stocks.
Some of the fastest growing investments of the last decade have been Chinese tech and media companies. Companies like Tencent, Alibaba and Baidu have all benefited from growth in China and the fact that global companies have struggled to penetrate that market. In addition, just like their competitors from the United States, these are tech stocks that are involved in artificial intelligence and other innovative high-growth technologies.
Coca Cola is an example of a company that has proved to be a very good long-term value investment. Every few years its share price will put it on attractive value. At the same time, the company has great long-term fundamentals that lead to steady earnings growth over time.
Large cap value stocks over last decade include Proctor & Gamble, Johnson & Johnson and AT&T. While Apple is best known as a growth stock, its valuation has been attractive over the last few years too. IBM is also a former growth stock which is now appearing in value portfolios. Other prominent value stocks in the IT sector are Intel and Cisco.
Insurance and healthcare stocks are amongst the most reliable value stocks. Their growth isn’t spectacular, so they are often ignored, but they do offer reliable and steady earnings. If they are purchased at a good price they can generate market beating returns for years. Berkshire Hathaway has exposure to insurance as well as stocks regarded as steady long-term investments.
Banks like JP Morgan and Citigroup are also frequently categorised as value stocks. They do tend to trade at attractive valuations but can be very exposed during a financial crisis like 2008.
High street retail stores have been one of the worst performing sectors of the last decade. While many of these companies appear to be in terminal decline, value investors do see value in selected stores. These types of turnaround plays are at the riskier end of the value spectrum.
Pros and cons of growth investing
A long-term growth investing strategy can result in exceptional returns. Capital can continuously be moved into the stocks with the strongest prospect of growth. In theory this is the most efficient way one can allocate capital. In reality, success depends on getting the timing right.
Growth stocks frequently end up in a bubble. This can be both an advantage and a risk. If you invest in a stock before a bubble forms, you can ride the momentum and earn higher than expected. On the other hand, prices can fall very rapidly once the bubble bursts.
Growth stocks are often very expensive, and high value stocks can experience steep declines when growth slows, and shares rerate. In some cases, you will need to get in and out of a stock before other investors. In other cases, you will need to hold a stock through deep drawdowns – as has been the case with stocks like Amazon and Netflix.
Growth investors must be able to tolerate volatility. Separating the real growth potential of a company from the hype surrounding the stock can be difficult. You will need to have a good understanding of both the companies and the markets they operate in, market sentiment and crowd psychology.
Pros and cons of value investing
Value based investing, when done well should result in fairly low volatility. A well-managed value portfolio can reduce the volatility of a broader portfolio. Value investing is based on tangible evidence rather than on expectations about future revenue, margins and the economic environment. Value investing is less prone to the effects of hype and sentiment, and therefore requires less guess work.
Finding quality, undervalued stocks is time consuming. Most stocks that appear cheap, are cheap for a reason. You will need a good understanding of financial statements and accounting to identify opportunities worth committing capital to. You may need to specialise in an industry to build an information edge. Buying stocks based on value means betting against the herd. You will need to be happy buying when others are selling and holding contrarian views.
In many cases when you invest in companies based on value, the time horizon will be uncertain. Just because a stock is undervalued, it doesn’t indicate it will recover in the next few months or even years. Value investing tends to be cyclical and goes through periods of outperformance followed by periods of underperformance. A lot of patience is therefore required.
Which investment strategy is better: Growth or value?
When it comes to picking the best investment style, there are two things to consider. Firstly, one of these approaches will probably make more sense to you than the other. Value investors are often more risk averse and place more emphasis on a company’s income statement and balance sheet. Growth investors tend to be more interested in consumer and technology trends, innovation, and market sentiment. Growth investors need to believe in the strength of a trend and the ability of a company to keep innovating.
Secondly, even if one approach appears superior, it may not remain so forever. Until recently, it was widely accepted that value investing had the edge over the long term. However, value stocks have underperformed since 2008, and the long-term stats are now less clear. This underperformance is partly a result of a new digital economy emerging, and partly a result of very low interest rates. Whether growth stocks will continue to outperform or not is impossible to know.
How growth and value investing can complement each other
Whether growth or value investing is the better strategy is debatable. However, one thing we can be reasonably sure of is that they can complement one another very well. A value investing strategy will typically have lower volatility than a growth investing strategy over time. At the same time, it is worth investing in growth companies for exposure to growing industries and economies.
Both approaches can also be used for stock picking alongside a more general mutual fund or ETF investing program. The core / satellite approach to investing uses passive investing products to earn beta, and slightly riskier assets to earn alpha. Value and growth stocks can therefore be used in this way to improve performance.
While value investing is more immune to volatility, both strategies can experience short term declines. For this reason, including hedging strategies alongside stock picking strategies is required to reduce portfolio risk. Hedge funds that engage in short selling can be used to reduce volatility even more.
Catana Capital’s Data Intelligence Fund is a long / short hedge fund. This means unlike both growth and value stocks; its returns have a low correlation with the overall market. The fund uses real time data to measure market sentiment, further reducing correlation with long term investing strategies
Conclusion: Diversify your portfolio with growth stocks and value stocks
Value and growth investing are both legitimate, proven methods of investing in the stock market. Yet, as you can see, neither approach is failproof and both styles have their strengths and drawbacks. The two styles are best used to complement one another, or as part of a more diversified portfolio. Both approaches require a certain amount of skill and experience. If one or other method resonates with you, it may be worth developing that skill. If not, it’s best to invest in appropriate ETFs, mutual funds or hedge funds.