Investors are constantly faced with the decision between risk and return. The same logic applies to growth versus value stocks. Rationale investors will agree that picking a quality stock is important; but not everyone agrees that value is more important than growth.
In this publication, we're going to discuss the topic of choosing growth versus value stocks. We'll start that discussion with a definition of each concept, highlighting the differences between these two groups of investments. As part of that discussion, we'll talk about an approach to identifying these stocks, and provide an example of each type. Finally, we'll provide historical data on the returns for each group, as well as a possible solution to this dilemma.
Investor Decision: Growth or Value
One of the nice features of the stock market is the range of choice investors have when making an investment decision. Unfortunately, this flexibility also results in tough decisions too; especially when it comes to fundamental investment strategies such as the choice between growth and value. To help make that decision a little easier, let's look at each investment type in more detail.
Generally, a growth stock is one that is expected to generate earnings at a rate that exceeds their industry's average. These companies usually possess a competitive advantage that allows them to generate these above-average profits. This might include a patent, manufacturing scale, or loyal customers.
Growth stocks will usually not pay dividends; instead they will quickly reinvest profits into new capital projects that will further increase profits. Investors in these companies pay little attention to the stock's price, only its future earnings potential.
Identifying Growth Stocks
The easiest way to identify these stocks is by looking at its historical earnings growth rate. The rate for a specific company can then be compared to their industry average.
Example: Growth Stock
In June 2011, Apple Computer was a good example of a growth stock. The company experienced a five year earnings per share growth rate of 58.8%, which was well above their industry average. The company does not pay a dividend, and had projected earnings of nearly $25.00 per share.
The idea of value investing has its roots in the work of the Benjamin Graham. The strategy behind this concept is an approach to selecting stocks that appear to be underpriced by the market. This may include companies that have low price to earnings ratios, or high dividend yields.
Because value stocks are selling at relatively low ratios, investors feel these companies are being ignored by the market. Investors believe such stocks are "bargains," since they are priced below what fundamental analysis would indicate is a "fair" amount.
Identifying Value Stocks
Investing in these stocks involves identifying excellent companies with high intrinsic value. These companies have a history of stable earnings, high return on equity, and provide earnings that are high relative to risk-free investments. We cover the topic of picking value stocks more thoroughly in our series: Stock Research.
Example: Value Stock
In June 2011, AT&T was a good example of a value stock. The company experienced a five year earnings per share growth rate of 17.7%. The current ratio was 0.74, the return on equity was 17.90%, and the dividend yield was 5.61%. AT&T also had a relatively low price to earnings ratio of 8.98.
Now that we understand the difference between value and growth stocks, it's time to look at some real-world data that provides some insights into the performance of each approach. At a high level, value investors are looking for bargains, and growth investors are looking for proven winners.
Morningstar is the premier source of information on mutual funds. Fortunately, they categorize these funds into growth and value, as well as large versus small cap funds. The information below summarizes the historical returns of both value and growth domestic stocks as of early June 2011.
From the above table of information, we can make several observations:
Risk and Return
Interestingly, growth stocks were also found to be of higher quality than value stocks. The quality of stock was measured by the average bond rating of each portfolio. Normally, investors should expect to be paid a premium for holding riskier stocks. That is to say, the lower quality value stocks should have provided higher returns.
In the above example, it seems like growth investors had the best of both worlds. Not only did they invest in higher quality stocks, but their returns were higher too. This finding doesn't mean the strategy of value investing should be abandoned, because there is a downside to growth investing too.
Historically, studies have shown that growth stocks have beta values which are higher than value stocks. As a reminder, beta is a measure of a stock's volatility relative to an overall measure of the stock market, such as the S&P 500 Index. Stocks with higher beta values experience greater price movements or swings.
So while growth stocks provide investors with greater returns, that return comes at a cost: greater variability in returns.
These two strategies also reveal the underlying viewpoint of each investor type. Value investors rely on the perspective that the future will be brighter for their stocks, while growth investors are hoping that historical performance continues into the future.
The down side of the value approach is there could be a very good reason a company is underpriced by the market. The down side of the growth approach is that past performance may indicate the run up in a stock's price is over.
We've also seen that growth companies provide greater returns to investors. Value companies achieve greater stability of earnings, and provide investors with a steady source of income in the form of dividends. In the end, neither group is a standout.
Fortunately, we don't have to choose one type of stock over the other. We can leverage the knowledge we have about their strengths and weaknesses to build a portfolio of stocks that suits our needs and risk tolerance. In fact, blend mutual funds are a great example of an offering that balances the pros and cons of each investment type.
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