At different periods of time, the stock market appears to favor one of two stock types - value stocks or growth stocks. Since the 2008 market downturn, for example, the market has primarily favored growth stocks. But some big names are speculating that value stocks could be making a comeback due in part to big changes caused by the pandemic. These speculations, of course, do not guarantee performance.
As you watch what’s happening in the markets, it’s important to know what the difference is between value stocks and growth stocks and appreciate the benefits of owning both. Just like having a mix of pulled pork and brisket in your life (for my Tennessee and Southeastern peeps!), there are benefits of owning both value and growth stocks.
What Is Value Investing?
The idea behind value investing is that investors are, essentially, bargain hunting. They’re looking for stocks that they believe are being undervalued by the market. Technically, a value stock can be defined as stock that trade “at a low price relative to a measure of fundamental value such as book equity.”1 If they consider a stock to be underpriced, it’s an opportunity to buy. If they consider it overpriced, it’s an opportunity to sell. Once they purchase a stock, value investors seek to ride the price upward as the security returns to its “fair market” price – selling it when this price objective is reached. Essentially, the proponents of value stock investing rely on the theory that paying less for a set of future cash flows corresponds with a higher expected return (but does not guarantee such, of course). This is one of the tenets of evidenced based investing. For those of you who know our approach at Oasis Wealth, we do adhere to the tenets of evidence-based investing.
To determine a value investment, investors may examine the company’s balance sheet, financial statements and cash flow statements to get a clear picture of its assets, liabilities, revenues and expenses.
Risks of Value Investing
There’s no guarantee that a stock will appreciate in value as much as an investor expects it to. A stock an investor believes to be undervalued may remain undervalued, or even drop in value.
What Is Growth Investing?
Growth investing essentially uses today’s information to identify tomorrow’s strongest stocks. The idea is to look for “winners” - stocks of companies within industries that are expected to experience substantial growth. Dimensional Fund Advisors define growth stocks as stocks “trading at a high price relative to a measure of fundamental value such as book equity.”2
Growth investors seek companies in a position to generate revenues or earnings greater than what the market expects. When growth investors find a promising stock, they buy it, even if it has already experienced rapid price appreciation, in the hope that its price will continue to rise as the company grows and attracts more investors.
Where value investors may use analysis, growth investors use criteria. Growth investors are more concerned about whether a company is exhibiting behavior that suggests it will be one of tomorrow’s leaders; they are less focused on the value of the underlying company.
For example, growth investors may favor companies with a sustainable competitive advantage that are expected to experience rapid revenue growth, that are effective at containing cost and that have an experienced management team in place.
Risks of Growth Investing
Growth investments may have an above-average price-to-earnings ratio (PE ratio), but they may in some cases be prone to higher volatility than value investments. These investments are typically bought at an already high price, and there’s always a risk that the price will fall or cease to rise any further.
Value investing and growth investing follow the same general purpose - to buy low and sell high. While they can often overlap in criteria, the key difference between these two guiding principles is this: value investments have generally already proven their worth, while growth investments show potential for future worth. In other words, both investment types are banking on the assumption that the value will rise, but for different reasons.
Having both Value and Growth Leads to Better Diversification
The benefits of owning both value and growth stocks should not be understated. The diversification that can be achieved can lead to more predictable and less volatile returns. Coupling the diversification with intelligent rebalancing can potentially lead to even better results over the long-term.
This does not mean one should own an equal amount of growth versus value stocks. While some investors try to chase where the next fad is going, at Oasis Wealth we generally adhere to the disciplined process that evidenced based investing suggests. Over the long-term, we still believe in the “Relative Price Premium” that value can offer compared to growth stocks over the long-term. For a more academic reading of value versus growth that includes charts looking at such “value premium”, please see Dimensional Fund Advisors article: “When It’s Value v. Growth, History is On Value’s Side.”
Implementation of Investment Style is Still Key
The decision on how much to allocate to any type of stock – whether it is value versus growth or market cap or domestic versus international – should be made in context of your overall portfolio and goals. Once you decide on the right mix of value versus growth – as well as other asset classes and factors – proper implementation can lead to better results. As the study by Dimensional Funds explains, there can still be wide variety among fund managers. See “Expectations v. Reality in Value Funds” for more information.
Needless to say, proper implementation of one’s overall investment strategy, and not just value versus growth, is a key to success. Knowing at a high level what to do does not mean the critical details and execution are necessarily known or followed. At Oasis Wealth, we know not all fund managers are equal, and we also realize that helping our clients avoid behavioral mistakes in portfolio management is one of the big reasons that clients hire us.
So, as you decide what asset class mix your portfolio should consist of, consider whether you have the right mix of value versus growth stocks based on your individualized situation. Taking an approach that “as long as I am in a broad index in the stock market” may not be the optimal approach to helping you reach your financial and retirement goals. If you want to learn more about how we craft a portfolio – coupled with a focus on income tax minimization and life planning – feel free to reach out to us at Oasis Wealth. We serve clients throughout the Southeast. We are licensed in Tennessee, Georgia, Florida and Alabama, serve clients in Indiana (our home roots) and Texas, and can serve most other states where we are exempt from licensing.