Growth Vs Value Investing: Which Gives Higher Returns?
Let me guess, you're a value investor.
I am sorry, but if that’s the case, you're missing out on Apple, Tesla, and Amazon.
Everybody knows that value is dead.
Wait, wait, wait, don't tell me that you're a growth investor, only another fool would buy the same thing as everyone else and think they're going to beat the market.
That’s right everyone, okay so we are back today with a comparison video: growth investing versus value investing.
It might not be a very distinct difference, but it's still important to understand.
These are two of the most popular fundamental approaches to investing, and chances are you're currently employing one of them if you actively invest through mutual funds or ETFs.
While both styles of investing belong to the same school of thought, they employ polar opposite criteria for selecting investments, so let's go over growth and value investing and how they square up on today's article.
Growth Investing
Growth and value investing are two contrasting approaches within the fundamental school of investing.
Growth investing is a dynamic and quick-moving method that has gained popularity and proven to be successful in the last few years.
In contrast, value investing is a patient and steady philosophy made famous by Warren Buffett.
These two methods are extensive and can be further divided into many different strategies.
However, investors can generally classify stocks under one of these two approaches based on three characteristics, with the first being:
#1: Growth Of The Underlying Company
Growth investors focus primarily on how fast a company's revenues, profits, and cash flows are increasing on an annual basis.
The goal is to invest in companies that are growing at a faster rate than the market to earn above-average returns.
Growth investors look for the next big thing in tech, artificial intelligence, or groundbreaking products that are on an upward trend and have the potential to dominate the market.
This makes it particularly attractive for novice investors who are learning how to pick stocks.
Typically, investors screen companies that have experienced at least a couple of years of rapid expansion, usually above 20%.
As a result of this requirement, these companies tend to be younger and smaller. However, it is not a prerequisite for growth investing.
Nowadays, there are several established behemoths like Microsoft and Amazon that continue to grow at a fast pace, so these companies are commonly considered growth investments despite their size.
Value Investing
Value investing, in contrast to growth investing, prioritizes stability and doesn't look for those flashy companies that are breaking records or promising to change the world when selecting stocks.
Value investors often choose more mature companies, think boring and stable companies like Coca Cola and Johnson and Johnson, that might be experiencing a decline in growth but have solid fundamentals.
That’s not to say that value investors don't want growth in their positions, but it isn't the primary criteria that they use to pick their stocks, that instead comes from our second criteria:
#2: The Stock’s Valuation
This is similar to a bargain hunter, where you would be finding the diamond in the rough and paying 95 cents for every dollar.
The idea behind this is that stock prices often deviate from their true worth, or intrinsic value.
So rather than seeking high growth rates, value investors focus on the stock's valuation, seeking to identify stocks that are currently undervalued in the market.
By purchasing these undervalued stocks, investors hope to profit when the stock price eventually corrects itself and returns to its fair value.
This approach often involves investing in mature companies that are currently out of favor with the market due to some temporary headwind, and sometimes even putting money in declining or bankrupt companies if the investor believes they will receive more money back than they put in through the liquidation process.
Determining Intrinsic Value
There are several methods for determining a stock's intrinsic worth, but one common approach for comparing value and growth stocks is using the P/E multiple.
This metric divides a stock's price by its earnings per share to show how much an investor is paying per dollar of annual profit.
Other multiples, such as price-to-book value or EV/EBITDA, may also be used, but we will stick with P/E ratio for now.
The P/E ratio shows how much an investor is willing to pay for stocks’ operations and by comparing it to the multiple of peers and the market as a whole, investors can see which companies are cheapest in their industry.
For example, a value investor may come across an ice cream company with a P/E ratio of 5 times, while other ice cream companies are trading at a P/E of 10 times.
The investor may conduct research on the company and determine that it has strong fundamentals and a good management team.
With the belief that the company will eventually return to a P/E multiple of 10, the investor may decide to buy the stock knowing that even if things stay flat, they aren't really paying too much for the stock, so there's less risk if things don't go the way they expect.
However, value investors do not buy stocks solely because they are cheap. They also conduct fundamental research to ensure that the companies they invest in will perform well over time.
Now, some value stocks may experience high growth, the idea is to limit the amount paid for these stocks to reduce risk.
On the one hand, growth stocks are typically more expensive with high P/E ratios.
These companies often trade at 30, 40, or even 100 times their earnings within the growth sector.
Sometimes the P/E ratio doesn't even apply because these companies lack earnings to justify their valuation.
However, these firms draw lots of investors’ attention due to their higher than average growth rates, which lead to higher valuations, despite having lower profitability.
Now this can make it harder for the investor to earn a return, because you are paying a premium for these stocks, and you'll need to earn more to justify the investment, but growth investors will pay this price if they believe the growth of the stock is worth the price tag.
For instance, a growth investor might find a tech company with a P/E ratio of 30, this may seem expensive in terms of its multiple.
But the investor might move forward with the purchase if they see that the underlying company is growing rapidly.
If the company doubles its operations in a couple of years, the stock won't seem so expensive for what the investor paid for it.
Hence, the growth of the underlying company and the valuation of its stock are two important characteristics of value and growth investing, and each approach focuses on one of these two characteristics.
The final factor that sets growth and value stocks apart is:
#3: The Level Of Volatility In Their Stock Prices
While this is not typically a factor that investors consciously consider when choosing which stock to invest in, growth companies tend to be newer with higher valuations and therefore their stock prices can fluctuate more than those of value stocks, which are often more stable.
For example, a growth stock may see returns of 25% one year, followed by a drop of 30% the next year, and then a return of 70%.
In contrast, a value stock may offer a more consistent and boring return of around 7% per year.
Pros And Cons
So these are the distinguishing characteristics that separate the different types of stocks, each with its own set of advantages and disadvantages.
Growth investing offers the advantage of higher potential returns, especially if an investor can identify an early-stage company that goes on to become a dominant player in its industry, this would make the investor fairly wealthy.
However, this approach also comes with greater risk due to the volatility of growth stocks and their tendency to be priced based on the expectation of future exceptional growth, even when there is little historical evidence to support it.
This becomes problematic given that investors pay a premium for these stocks.
If an investor pays a 30 times multiple for a company that has been growing 30% a year, but in the next year, the company only reports a 10% growth, this shortfall in growth can lead to a significant drop in valuation as the market suddenly removes its growth premium.
In fact, some say these companies are "priced for perfection," which means that anything short of perfection can have a significant impact on the stock price.
In value investing, the advantage is that it's usually a stable and less risky approach.
Value investors typically invest in established companies with a proven track record, reducing the likelihood of sudden changes affecting their stock prices.
However, the downside is that it can take a long time for the stock's value to increase, and even if you identify an undervalued stock, it may not be a good investment if it takes 20 or 30 years for its value to be realized.
Additionally, value investors can fall into the "value trap," where they focus too much on buying cheap stocks and end up with poor investments that only get cheaper.
Just because a stock is inexpensive doesn't mean it's a good investment, and there's always the risk that the valuation will drop even further than what it currently is, if the company's underlying business is deteriorating.
Even if you find a company at five times multiple, it's all for nothing if it goes bankrupt, right?
Which Is For You?
So as you can see, both growth and value investing have their own advantages and disadvantages, but what you might be wondering then is which one should I choose?
And the answer depends on when you ask the question.
According to a study by Bank of America Merrill Lynch, value stocks outperformed growth stocks over a 90-year period starting in 1926, earning an annual return of 17%, compared to growth stocks' 12.6%.
However, in the past decade, growth stocks have outperformed value stocks by a significant margin, leading some to believe that value investing is no longer effective.
But there are others that see it as a sign that the markets have become too optimistic and a reversal is imminent.
Regardless, it's clear that the performance of value and growth investing varies during different market conditions, with growth stocks taking the lead during extended bull market conditions.
So rather than strictly adhering to one investing style or the other, many people diversify their portfolios by holding both growth and value positions, or they can also use hybrid strategies as well.
One such way is GARP (Growth at a Reasonable Price), which involves investing in growth companies with solid fundamentals that aren't too expensive, which by definition kind of balances the 2 different investing styles.
While most investors may identify as either growth or value investors, the truth is that all of us are simply looking for solid companies to invest in.
So there's really no need to compete, as everyone has different levels of investing skill, and it's important to find a strategy that works for you.
- Ivan