Growth vs Value Stocks is a comparison which all investors will do at some point of time in their lives. Which one of these is better? We will find out.
Growth stocks is a term used to denote stocks that possess the potential to outperform the market over the course of time. These stocks are expected to outperform the market based on their future potential. Value stocks is a term used to classify stocks that are undervalued, or trading at a price lower than their actual worth. This ensures that their returns will be good. Growth vs Value stocks is a question which most investors have on their mind. In case you are wondering which category is better for you, this post will help clear it out for you. Let’s get started.
Growth vs Value Stocks: What’s better?
Growth Stocks vs. Value Stocks
As per analysts, growth stocks possess a great potential to outperform the entire market (or a specific segment of the market) over a period of time.
Growth stocks are usually found in small-, mid- and large-cap sectors. However, they can’t be growth stocks forever. Once the analysts feel that the stocks have achieved their growth potential, they aren’t called growth stocks anymore. Companies which have growth stocks are expected to expand considerably over the next few years. This expansion is usually brought about by a product or line of products that are expected to sell well. It can also be caused by the fact that these firms appear to run better than their competitors and that is expected to help them earn an edge in the market.
A value stock is generally traded at an equity price lower than the stock price of certain companies within the industry. The dividends, earnings, or sales are lowered to make it more appealing to value investors. Investors use this to calculate the value of the stock of a company:
Price-to-book ratio (P/B ratio) – It’s calculated by dividing the company’s stock price by its book value per share. Book value is the total assets minus any liabilities. Low P/B ratios can be indicative of undervalued stocks, and can be useful when finding a value stock.
Price-to-earnings ratio (P/E ratio) – Calculated by dividing the company’s stock price by its earnings per share. P/E ratio helps to determine the relationship between the stock price in the market and its actual earnings as per books. Low P/E ratios indicate that the stocks are undervalued and thus have a chance of future increment in share price.
Price-to-sales ratio (P/S ratio) – Calculated by dividing the market capitalization by the company’s total sales or revenue. Market capitalization means the total outstanding shares multiplied by the share price per share in the market. A low P/S ratio indicates a good buy as the stock is undervalued.
A value stock will have a bargain-price as investors see the company as unfavorable in the marketplace. Or VS can be within a sector that trades at a discount to the broader market. Negative publicity from low earnings reports or legal problems also indicates a value stock as the market will negatively view the company’s long-term value.
A value stock will most likely come from a mature company with a stable dividend issuance that is temporarily experiencing adverse events. But, companies that have recently issued equities have high-value potential as many investors may be unaware of the entity.
However, neither of these outlooks are perpetually correct. There are also some stocks which can easily be classified as a blend of both the categories. As a result, Morningstar Inc. classifies all of the equities and equity funds that it ranks into either a growth, value, or blended category.
Which Is Better?
When we try to compare the historical performances of growth and performance stocks, the results need to be evaluated in terms of time horizon and the amount of volatility, also accounting for the risk that was taken on the way of achieving them.
Value stocks theoretically possess a lower level of risk and volatility because they are usually found among larger, more established companies. Even in scenarios where they fail to return to the target price that analysts or the investor predict, they will still provide significant capital growth. These stocks also pay good dividends.
Despite all the pros, value stocks are usually expected to be riskier than growth stocks because of the skeptical attitude the market has toward them. Investing in value stocks or value investing depends on a premise that the market is eventually going to recognize the potential of undervalued stocks and the price will rise accordingly, helping the investors earn significant profits.
In order for value stocks to become profitable, the market needs to change the company perception which is definitely far riskier than a growth entity developing. The underlying risk leads to value stocks having a higher long-term return than a growth stock. One of the biggest risks associated with investing in a value stock is the probability that the potentially undervalued stock never realizes its projected value.
Growth stocks, meanwhile, will usually refrain from paying out dividends and will instead reinvest retained earnings back into the company to expand. Their loss probability can also end up being higher, especially if the company is unable to keep up with growth expectations.
Let’s take the example of a company whose new product actually ends up being a flop and that is bound to lead to a drop in the stock price. Growth stocks tend to be very high risk-high reward style of investment.
Growth vs Value Stocks: Historical Performance
Based on what we discussed above, we might draw the conclusion that growth stocks would post the best numbers over longer periods. However, the opposite has actually been true. This is based on a Seeking Alpha report published by research analyst John Dowdee in which he broke stocks down into categories that reflected both the risk and returns for growth and value stocks in the small-, mid- and large-cap sectors, respectively.
The study reveals that from July 2000 until 2013, when the study was conducted, value stocks outperformed growth stocks on a risk-adjusted basis for all three levels of capitalization, despite being much more volatile than their competition.
But this was not the case for shorter periods of time. Between 2007 to 2013, growth stocks yielded higher returns in each cap class. John Dowdee ultimately concluded that the study didn’t really come up with a concrete answer as to which type of stock was truly superior to the other on a risk-adjusted basis. He stated that the winner in each scenario came down to the time period during which they were held.
Constrastingly, is a study published in the Financial Planning magazine, Craig Israelsen demonstrated the performance of growth and value stocks in all three capsizes over a 25-year period from the beginning of 1990 to the end of 2014. The returns on this chart show that large-cap value stocks provided an average annual return that exceeded that of large-cap growth stocks by about three-quarters of a percent. The difference proved to be even larger for mid- and small-cap stocks This info was derived on the performance of their respective benchmark indices and the value stocks came out on top once again.
The study also went on to demonstrate that over every rolling five-year period during that time, large-cap growth and value stocks performed very similarly. Small-cap value beat its growth counterpart about three-quarters of the time over those periods, but when growth prevailed, the difference between the two was often much larger than when value won. Over rolling 10 periods, small-cap value stocks outperformed growth stocks almost 90% of the time. Mid-cap value stocks also outperformed their growth stocks counterpart during the same timeframe.
Growth vs Value Stocks: Conclusion
Regardless of all kinds of detailed analysis and data crunching, the ultimate choice between growth and value stock depends upon the investor’s preference. An investor’s personal risk tolerance, investment goals, and time horizon also matter. However, investors must remember that over shorter periods, the performance of either growth or value is also dependent largely upon the point in the cycle that the market happens to be in.
Value stocks usually outperform other stocks at the time of bearish markets or recessions. Growth stocks on the other hand, provide the best returns during bullish markets or phases of economic expansion and growth. So if you are a short term investor or an investor who is trying to time the market, ensure that you take these factors into account.