Investors have long debated the merits of value vs growth stocks. Indeed, there are successful investors on both sides of the argument. But the truth is the performance of these equity styles tends to ebb and flow over time. In most cases, long-term investors need not concern themselves with the value vs growth debate. Instead, it may be more beneficial to understand when each style typically outperforms the other—and why.
Value and Growth Stocks Defined
According to CFA Institute, a value stock trades at a price below its fundamental value. In other words, you can think of value stocks as trading at a discount or “on sale” because the market hasn’t yet recognized its worth. Additionally, value stocks are more likely to pay dividends—though not all do.
On the other hand, growth stocks typically indicate higher future corporate earnings. While they may be more expensive than value stocks, growth stocks may also have more room to appreciate given future business prospects and industry dynamics. In addition, these companies are more likely to reinvest earnings in themselves rather than pay them out in dividends.
Historically, value stocks tend to be concentrated in sectors like financials, energy, and utilities. Meanwhile, sectors like healthcare and technology are typically more growth oriented. However, that doesn’t mean value and growth stocks are limited to certain market sectors.
Key Characteristics of Value Stocks
“The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.” –Benjamin Graham
While there may be exceptions, value stocks tend to exhibit the following characteristics:
- Undervalued compared to their peers: Value stocks trade at lower prices than similar companies in their sector or industry. They are most attractive when share prices fall but a company’s underlying fundamental characteristics remain strong.
- Lower price-to-earnings (P/E) ratios than the broad market: Beyond a company’s industry competitors, value stocks tend to be priced lower than the broad market—and especially growth stocks—in terms of P/E ratio.
- Reliable income streams: Larger, more established value companies that generate consistent earnings often pay them out directly to shareholders in the form of dividends rather than reinvest them in the business.
- Less volatile than the broad market: Since value stocks tend to be priced more conservatively than growth stocks, their share prices tend to be more stable. However, investors should beware of value traps—stocks that appear attractive based on price but continue to fall in value due to weak fundamentals.
Key Characteristics of Growth Stocks
“No one can see ahead three years, let alone five or ten. Competition, new inventions – all kinds of things – can change the situation in twelve months.” –Thomas Rowe Price, Jr.
While there may be exceptions, growth stocks tend to exhibit the following characteristics:
- Recent earnings and revenue growth: Though typically less mature than value stocks, growth stocks tend to have better-than-average revenue and earnings growth in recent years. Investors expect this growth to continue in the near-term, justifying their higher prices.
- Higher price-to-earnings (P/E) ratios than the broad market: Growth stocks tend to have higher valuations than value stocks and the broad market. However, a strong forward P/E ratio typically indicates an expectation of continued growth.
- More growth potential with less consistent ROI: Since growth companies tend to reinvest earnings rather than pay dividends to shareholders, an investor’s ROI depends on the stock price increasing. Although they may generate less stable returns than dividend-paying stocks, growth stocks have the potential to appreciate faster and more meaningfully.
- More volatile than the broad market: The prices of growth stocks tend to be more volatile than value stocks given their high valuations. Already high share prices can plummet quickly if a company misses earnings expectations or negative news about the company emerges.
Value and Growth Performance Over the Years
Academic research shows that historically, value has outperformed growth over longer periods of time. In 1992, researchers Eugene Fama and Ken French published their Three-Factor Model, which introduced this concept (also known as the value premium). Though the value premium still exists, recent research indicates that it’s shrinking.
Nevertheless, there have been periods throughout history when value outperformed growth. Likewise, there have also been stretches of time when growth has outperformed value. The following chart illustrates the ebb and flow of value vs growth stock outperformance over the last 40 years.
The trade-off in outperformance makes sense when looking back on the major events that have driven stock market returns. More recently, growth stocks outperformed value stocks leading up to and until the peak of the Tech Boom. When the bubble burst, value stocks took the lead and outperformed heading into the 2007-2009 Financial Crisis. Value stocks have largely underperformed since the Financial Crisis except for the first half of 2021.
Expectations for Value vs Growth Stock Performance
It may appear that value investing has lost its appeal in recent years. However, there are external factors to consider for why this may be the case. The stock market’s recovery from the Global Financial Crisis marked the longest bull market in U.S. history. At the same time, interest rates have been historically low. Growth stocks tend to perform best when interest rates are falling, and corporate earnings are rising.
On the other hand, value stocks often take the lead when the economy is cooling. These stocks may also perform well in the early part of an economic recovery. However, they tend to lag during sustained bull markets.
Value vs Growth in a Diversified Portfolio
Indeed, there are times when it pays to invest in growth stocks. There are also times when investing in value stocks is more rewarding. Long-term investors often benefit from holding both.
That said, the proportion of value vs growth stocks in a portfolio may vary from investor to investor based on your objectives. For example, investors who are many years from retiring and can withstand more volatility may want to hold more growth stocks in their portfolio. These investors are more focused on growing wealth and typically aren’t worried about generating income from their investments.
Alternatively, investors who are nearing or in retirement may be better served by holding more value stocks. Value stocks tend to be more stable than growth stocks and often pay dividends, which can be a meaningful source of income in retirement.
It’s also important to note that style (value vs growth) isn’t the only factor to consider when constructing a diversified stock portfolio. Company size, industry, and geographic location can also impact performance. Moreover, the relative performance of value vs growth stocks may be more nuanced depending on these factors.
Investing for Your Future
The bottom line is that the relative performance of value and growth stocks tends to be cyclical. Growth stocks have enjoyed an extended period of outperformance recently. However, the characteristics supporting that outperformance may be shifting.
For example, the Federal Reserve has indicated that an interest rate hike is possible in the near-term. While this move may not benefit growth stocks, rising interest rates tend to bode well for value-oriented sectors like financials.
Like most investment decisions, the value vs growth debate ultimately comes down to your financial circumstances, near-term needs, and long-term goals. A trusted financial advisor like Milestone Asset Management Group can help you develop an investment strategy that’s aligned with your objectives. Please contact us if you’d like to schedule an introductory meeting.