There are a number of investment strategies and styles for investors to consider when trying to build their portfolio and decide how to invest their money. You can choose basic asset classes such as stocks, bonds, and cash. Within stocks, you might consider large or small-cap stocks as well as domestic and international stocks.
Within these various types of stocks, there can be companies that are classified as growth stocks or value stocks. Growth and value investments have different characteristics that investors should understand as they build their investment portfolios.
Some investors might see growth and value investing as an either-or proposition. The reality for most of us who are not professional traders or market timers is that a well-balanced investment portfolio includes both investing styles as part of the portfolio’s asset allocation. Here’s what you need to know about what this all means.
Growth vs. value investing
|Growth stocks||Value stocks|
|Price||Fair or overvalued||Undervalued|
|Risk||Generally higher volatility||Generally lower volatility|
|P/E ratio||Higher than average||Lower than average|
|Current income||Tend to have lower dividend yields as these companies prefer to reinvest earnings back into the business.||Tend to have higher dividend yields as these companies often don’t have significant opportunities within the business in which to reinvest.|
|Goal||Ride the momentum of the stock||Buy undervalued stocks and hope that the market will push the price up|
What is growth investing?
Growth investing entails investing in stocks that are projected to grow at a faster pace than other stocks in their category.
Growth can be defined as “faster” than average based on the stock’s growth in several areas, including earnings, sales, book value, and cash flow. Growth stocks will generally have higher valuations as reflected by high price ratios and a relatively low dividend yield. Metrics such as price-to-earnings ratio (PE ratio), price-to-book ratio, and the price-to-sales ratio are typically higher for growth stocks than for value stocks.
Looking at Apple, its recent stock price-to-cash flow ratio was 24.16 compared with 17.54 for the average stock in Morningstar US Market Total Return Index. This means Apple’s price per share compared with the cash flow it generates on a per-share basis is 38% higher than the average stock in this total stock market index.
In addition, Apple’s recent price-to-book ratio was 38.11, which means its share price was 38.11 times higher than the equity per share available to shareholders. The ratio for the average stock in this index is 4.35 times. These factors mean we can categorize Apple as a growth company.
Typical stock market sectors for growth stocks include technology, consumer cyclicals (which includes retail, automotive, lodging facilities, and more), and communications services. Growth stocks can be found among large-cap, mid-cap, and small-cap stocks. (Market cap or capitalization is the value of the share price multiplied by the number of outstanding shares.) Additionally growth stocks can be found among international (non-U.S.) stocks in both developed and emerging markets countries.
There are a number of growth mutual funds and exchange-traded funds (ETFs), here are a few.
- Vanguard Growth Index (mutual fund: VIGRX; ETF: VUG)
- ishares Russell 1000 Growth ETF (IWF)
- Vanguard Mid-Cap Growth (mutual fund: VMGRX; ETF: VOT)
- PRIMECAP Odyssey Aggressive Growth ( POAGX)
- Vanguard Small Cap Growth (mutual fund: VISGX; ETF: VBK)
- ishares Russell 2000 Growth ETF (IWO)
As an example of some classic growth stocks, the top five holdings in the ishares Russell 1000 Growth ETF are:
- Apple (AAPL)
- Microsoft (MSFT)
- Amazon (AMZN)
- Facebook (FB)
- Alphabet (Google’s parent company, GOOGL)
When growth investing might be useful
Growth stocks are a key part of a well-diversified investment portfolio for most investors. Trying to time the market is generally a poor idea for investors, but growth stocks tend to outperform at certain times:
- During periods of rallies in the stock market
- During periods of economic growth
- During periods of rising corporate earnings and falling interest rates
Beyond these scenarios, certain growth stocks might do well based on economic situations that lead customers to the product or service they offer. The coronavirus pandemic propelled the earnings of many companies who offered online shopping, such as Amazon and others. Many of these growth stocks did well in 2020.
What is value investing?
Value investing involves buying stocks that are considered to be undervalued compared with the company’s expected value.
Investors might define a value stock using a number of different methods. They might use a discounted cash flow model, which involves forecasting the company’s future cash flows to determine its potential value, then comparing this potential value per share to the company’s current share price. They might also look at a stock’s price-to-earnings ratio or its price-to-book ratio to determine whether the shares represent a value at today’s current price.
As an example, we can look at JPMorgan Chase & Co. (JPM). Its recent stock price-to-cash flow ratio was 14.13 compared to 17.54 for the average stock in the Morningstar US Market Total Return Index. This means JPM’s price per share compared with the cash flow it generates on a per share basis is 20% lower than for the average stock in this total stock market index.
JPM’s recent price-to-book ratio was 1.82, which means its share price was 1.82 times higher than the equity per share available to shareholders. The ratio for the average stock in this index is 4.35 times. These factors mean we can categorize JPM as a value company.
There are a number of value funds and ETFs, here are a few.
- Vanguard Value Index (mutual fund: VIVAX; ETF: VTV)
- ishares Russell 1000 Value ETF (IWD)
- Vanguard Mid-Cap Value (mutual fund: VMVIX; ETF: VOE)
- Fidelity Low-Priced Stock ( FLPSX)
- Vanguard Small Cap Value (mutual fund: VISVX; ETF: VBR)
- ishares Russell 2000 Value ETF (IWM)
IWD is an ETF that tracks the value portion of the Russell 1000 index, a major large-cap stock benchmark. Its top holdings by industry segment include:
- Financial services: 21%
- Healthcare: 18%
- Industrials: 12%
- Technology: 10%
The specific top five holdings of IWD are:
- Berkshire Hathaway Class B
- Johnson & Johnson
- JPMorgan Chase
- UnitedHealth Group
- Procter & Gamble
When value investing might be useful
Trying to time the market is generally not a good plan for most individual investors. As with growth investing, a balanced portfolio that includes allocations to both value and growth stocks probably makes more sense than trying to determine when either investing style will outperform.
That said, there are some periods when history shows us that value stocks might be more likely to outperform:
- Value stocks might do well in the early stages of an economic recovery as previously undervalued stocks recover.
- Some studies have shown that value stocks outperform growth stocks over longer periods of time.
The leadership position of growth or value can change abruptly. We saw this in early 2021 as the market momentum swung back to value after a sustained period of growth stock leadership in part fueled by the stay-at-home and work-from-home trends of the pandemic. Many value stocks came back in part because they had been undervalued previously and the economy had begun to recover from the impact of the coronavirus.
Historical performance of growth vs. value investing
Perhaps surprisingly, the historical performance of value outpaced growth on average by 4.54% on an annual basis from 1928 through 2019, according to a study by the private investment firm Dimensional Fund Advisors. This may be a bit surprising to newer investors, as growth has largely outpaced value in recent years.
As of September 2021, value has outperformed growth over the past six months. However, over the past 10- and 30-year periods, it has mostly been growth leading the way. Over the 30-year time frame, value really only outpaced growth during the years of the financial crisis during the 2006-2008 time horizon.
During most of the past 30-year period, we’ve seen a prolonged period of growth and economic prosperity, with the emergence of many tech and tech-related names in the stock market.
Deciding on growth vs. value for your portfolio
For most investors, this is not an either-or choice. Most investors will want diversification in their portfolio holdings between growth and value. Further, they will want to do this across a variety of investment types — such as large-cap, small-cap, and mid-cap stocks — as well as across domestic and foreign stocks.
Although this can be done via individual stocks, for many investors, the asset allocation process can be done more efficiently by using mutual funds and ETFs. There are a number of funds and ETFs that blend growth and value. Examples include funds tracking the S&P 500 index, as well as indexes tracking the total U.S. stock market.
Looking at past performance should only reinforce the need to diversify among both growth and value. Unless you are a full-time investor, it is unlikely you will be able to determine which type of holding will do better over a given period of time. That said, your investments should also vary depending upon your age, goals, and time horizon.
How do you know if a stock is growth or value?
There is no hard and fast quantitative benchmark to determine whether a stock is growth or value. Growth stocks will generally have higher valuations as reflected by high price ratios and a relatively low dividend yield. Metrics such as price-to-earnings ratio (PE ratio), price-to-book ratio, and the price-to-sales ratio are typically higher for growth stocks than for value stocks. Another way to research this is to research the index ETFs where this stock might be held. Whether the ETF is a growth or value ETF could help with this identification.
Can a stock be both growth and value?
Conceivably, yes, a stock can be categorized as both growth and value. In fact, it’s not uncommon to see a stock held in both growth or value oriented mutual funds or ETFs. The parameters of what defines a growth or a value stock are not written in stone, which is why this might occur. The classification can depend on the investor or the investment manager’s interpretation.
Is Warren Buffett a value or growth investor?
Legendary investor Warren Buffet is perhaps the ultimate value investor. There are many quotations attributed to Mr. Buffett on the topic of value investing — here are a few:
- “Price is what you pay. Value is what you get.”
- “Just buy something for less than it’s worth.”
- “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Buffet’s company, Berkshire Hathaway, is the largest holding in several large-cap value index funds and ETFs including the Vanguard Value ETF (VTV) and the Russell 1000 Value ETF (IWD).
Growth and value investing are two popular approaches to investing in stocks. And many people on Wall Street have different opinions on how you vary your investments during a bear market or bull market.
Although some investors might choose to go all in on one or the other — growth vs. value investing — for most investors, an allocation to both growth and value stocks is part of a well-diversified portfolio. Beyond individual stocks, there are a number of ETFs and mutual funds across both investment styles that could help investors build out their portfolios.
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