Looking at Growth and Value Investment Approaches
Do you know the difference between a growth stock and a value stock?
They each have their own qualities, as well as risk and return characteristics. And understanding these distinctions can be very important in the investment world.
A value stock is best described as a stock that is undervalued based on its fundamentals. These stocks usually have strong cash flows, a solid balance sheet, and often pay a dividend, but their current market price may not reflect the past performance results of the company. Value-oriented industries include financial services, utilities, and energy.
Warren Buffett is the textbook value investor – he studies the fundamentals of companies closely to determine whether they are below a fair market price. After he invests in a company, he is patient because he knows the company’s valuations look favorable and that will eventually reflect in an increase in stock price.
Growth stocks, in contrast, are more focused on what could be than on what is. In other words, they are valued heavily on potential future earnings growth. Growth-oriented industries include technology, healthcare, and consumer discretionary (defined as goods and services people purchase when they have excess income).
Out of these categories, which one outperforms in terms of investment return and risk? On the risk side, since 1990 the value index has had roughly 5% lower standard deviation than the more volatile growth index. Looking at return, from 1926 to 2012 value stocks outperformed growth stocks 14.7% to 11.2%, or 3.5% annually. It seems almost a given that companies that are undervalued will out-perform their more expensive peers over the long-term. This trend is referred to as the “value premium.”
However, despite the long-term trend, this standard has found itself in reverse since the last recession ended in 2009. In fact, since 2009 the Russell 1000 Growth Index bested the Russell 1000 Value Index by a cumulative 85% as of June 2017.
Part of this deviation can be explained by the Federal Reserve’s low interest rate policy. In a low interest rate economy, many investors direct their attention toward growth stocks with higher projected earnings growth, as opposed to value stocks with more attractive fundamentals but weaker growth prospects. As the economy regains its health and the Federal Reserve can afford to raise interest rates, more stocks participate and investors grow sensitive to valuations, making value stocks typically outperform in a rising interest rate environment.
There have been cases where value stocks have outperformed growth stocks since 2009, mostly due to sector-specific trends. For instance, as oil prices bottomed out in early 2016, energy stocks got so inexpensive that as the price of oil recovered, energy was the top performing stock sector of the year.
With many factors influencing the performance of both value and growth stocks, it’s important to think beyond value vs. growth when making investment decisions. One thing to keep in mind is that gains in either category do not diminish the value of sticking to investment fundamentals when selecting securities. Both types of stocks can be good investments and have a place in a diversified portfolio, perhaps with a small tilt towards value due to historical performance and relatively less volatility.