When it comes to stocks, there are many different aspects for investors to consider before plunking money down. It can be helpful to lump company equities into two very broad categories in addition to the more nitty-gritty metrics investors often use to try to determine a company’s worth.
These categories, or styles, of stocks are often called “growth” and “value,” and while their definitions can be flexible and sometimes overlap, there are some broadly accepted ways of identifying these styles of stocks.
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Right now, as people worry about the economy tilting into a recession, it’s worth examining what growth and value stocks are and when to invest in them because the state of the economy and market can dictate which style of stocks investors may want to lean toward at any given time.
— What are growth and value stocks?
— Tips for identifying growth and value stocks.
— Pros and cons of value stocks.
— Pros and cons of growth stocks.
— When to invest in growth and value stocks.
What Are Growth and Value Stocks?
In general, growth stocks are those that are outperforming the market for some reason, while value stocks are those that are trading well below what they’re worth.
“Growth stocks are growing quickly and value stocks offer good value for their current price,” says Brian Huckstep, chief investment officer at Advyzon Investment Management. “These labels are quite squishy and there are many shades of gray in between growth and value.”
Determining if an equity is a growth stock depends a lot on expectations, as they appear to have above-average growth prospects, says Robert Johnson, finance professor at Creighton University and coauthor of “The Tools and Techniques of Investment Planning, Strategic Value Investing and Investment Banking for Dummies.”
“If earnings are expected to grow substantially in the future, then, all else being equal, the stock should be priced higher,” he says. Meanwhile, value stocks appear to be selling at a low price relative to a fundamental factor such as earnings, sales or book value, he says.
Keep in mind that some investments can be growth and value stocks at the same time, or what some analysts refer to as growth at a reasonable price, or GARP, Johnson says.
“A company may be growing its revenue, earnings and operating cash flow, and the current market price may not fully reflect that growth and future growth potential,” Johnson says.
Growth stocks can also be seen as companies that grow their revenue and income at above-average rates and generally plow their earnings back into the business instead of paying dividends.
Tips for Identifying Growth and Value Stocks
“There are many unique, valid ways to quantitatively define and identify growth and value stocks,” Huckstep says.
Price-to-earnings, price-to-book, price-to-sales and price-to-cash flow ratios are often-used financial metrics when trying to determine whether an equity is a growth or value stock, he says. Lower levels of each metric are associated with value stocks.
For very young growth companies, investors can look for stocks that rank as the opposite of value in these four metrics. Earnings growth, sales growth and cash flow growth metrics are also helpful when it comes to identifying growth stocks, Huckstep says.
“But for very young firms, these values can be a train wreck or simply zero,” he says. And that doesn’t necessarily mean the growth stock is a bad investment, as it’s quite common for startups to not be profitable for some time.
To identify growth stocks, some experts recommend looking for year-on-year revenue growth of 10% or more, expanding profit margins, and high reinvestment in research and development. For value stocks, you might search for a low price-to-earnings ratio, good dividend yield and solid earnings history.
Pros and Cons of Value Stocks
“The biggest pro of value investing is that historically value stocks have outperformed growth stocks over the long run,” Johnson says.
He points to an SBBI Yearbook study that showed from 1927 through 2022, value stocks significantly outperformed growth across large and small market capitalization stocks.
And because value stocks are typically more conservatively valued than growth stocks, they tend to have a larger margin of safety, which is an estimate of how much of a discount the stock is selling for relative to its true value, Johnson says.
“Value stock prices have often been beaten down too far, as investors fear losses more than they appreciate growth, a known psychological investing bias,” Huckstep says. “For that reason, their total returns can outpace growth stocks.”
Value stocks can also be more defensive, performing better than growth stocks during times of economic hardship. They also tend to offer steady returns and dividend income.
But there are downsides to owning value stocks as well.
For one thing, value stocks don’t outperform growth stocks all of the time and have had long periods of underperformance, Johnson says.
The same SBBI Yearbook study showed that large value stocks underperformed large growth stocks in the decades of the 1930s, 1990s and 2010s.
“Value investors need to exercise patience and have a long time horizon,” Johnson says.
There’s also the chance that a stock is priced cheaply for a reason. “Value stocks can sometimes be firms that are on the verge of default,” Huckstep says. Those that have fundamental defects can be what’s referred to as “value traps.”
Pros and Cons of Growth Stocks
Perhaps the primary reason for owning growth stocks is their potential to outperform the market. Over the past three decades in the U.S., growth stocks have outperformed value stocks, as America is known as the worldwide leader in technology innovation, giving the nation’s growth stocks a boost, Huckstep says.
With their high probability of upside, some investors turn to growth stocks during bull markets. But cons to growth stocks are that they are more volatile and usually don’t pay dividends.
It’s also true that each type of investment can be susceptible to multi-year bubbles driven up by overexuberance, Huckstep says. “Underweighting asset classes when they reach stretched valuation levels can help investors lower losses during corrections,” he says.
When to Invest in Growth and Value Stocks
Tech-heavy stocks such as the Magnificent Seven of Alphabet Inc. (ticker: GOOG, GOOGL), Amazon.com Inc. (AMZN), Apple Inc. (AAPL), Meta Platforms Inc. (META), Microsoft Corp. (MSFT), Nvidia Corp. (NVDA) and Tesla Inc. (TSLA) can all be characterized as growth stocks, Johnson says.
These stocks accounted for more than half of the S&P 500’s gains last year. But year to date, as evidenced by the return on the Roundhill Magnificent Seven ETF (MAGS), these stocks have underperformed the S&P 500.
“It appears that as economic conditions become more uncertain, growth stocks are losing favor and value stocks are gaining favor,” Johnson says. “Value investors tend to perform better than growth stock investors in recessionary environments, as value stocks have a higher margin of safety than growth stocks.”
Johnson says Berkshire Hathaway Inc. (BRK.A, BRK.B) represents a strong value stock. He notes the company was recently selling at a trailing-12-month price-to-earnings ratio of 12.7 and has over $330 billion of cash on hand. Johnson is a longtime Berkshire Hathaway shareholder.
UnitedHealth Group Inc. (UNH), Procter & Gamble Co. (PG), JPMorgan Chase & Co. (JPM) and Johnson & Johnson (JNJ) are others to consider now, some experts say.
When interest rates are rising, value stocks may do better because high rates are detrimental to growth stock prices. In times of economic expansion, growth stocks will outperform as investors search for higher earnings. Young investors tend to be growth-oriented, while retirees may be value-oriented for income security.
Even though there are times when value or growth outperform each other, typical investors generally don’t want to become overly concentrated in either kind of stock, Johnson says.
“While value stocks outperform growth stocks over certain periods, and vice versa, it is difficult, if not impossible, to identify those periods in advance,” Johnson says. “My advice for investors is to remain diversified across style, but given the long-term outperformance of value stocks, I would err on the side of having a value tilt in my equity portfolio.”
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How to Identify Growth Stocks and Value Stocks originally appeared on usnews.com
