One of the most common distinctions drawn in the world of stock investing is that between growth and value. These labels are routinely applied to individual stocks, market sectors, indexes, investors and mutual funds.
Put simply, the growth investment style seeks companies whose earnings are expected to grow faster than the broad market, while the value style seeks stocks that are believed to be priced below the companies' actual values. Wise investors understand the differences between the two, but the wisest know that a portfolio built around both growth and value stocks can be the true path to investing success.
What the Style Labels Mean
It would be difficult to talk about growth and value investing without first establishing what differentiates a growth stock from a value stock. The characteristics that typically distinguish each group are mostly taken from measurable data. But investors must keep in mind that additional, non-quantifiable factors such as market sentiment can sometimes blur the line between the styles.
Generally speaking, growth companies have a track record of higher-than-average earnings growth, and investors are willing to pay higher share prices for their future growth potential. This potential also represents the main risk of growth stocks because if earnings growth does not occur as expected, the share price may decline.
Value companies generally exhibit slower growth and sell at lower prices. A stock is only a true value if the company is fundamentally sound and its share price depression is temporary. Following are some general guidelines used to identify each type of stock:
|Characteristics/Risks of Growth and Value Stocks|
|Growth Stocks||Value Stocks|
|Characteristics|| || |
|Risks|| || |
Source:©2009 Morningstar, Inc. All rights reserved. Used with permission.
"The list of factors that can be considered a determinant of either growth or value characteristics is not limited, and there is very little agreement among researchers or analysts about which set of variables is most important."*
Sorting It All Out
While there is no universal formula for determining whether a stock should be categorized as growth or value, an analysis usually begins with the stock's price/earnings (P/E) ratio and/or its price/book (P/B) ratio. The P/E ratio is the current stock price divided by current earnings per share (i.e., the multiple of earnings at which the stock is selling). The P/B ratio is the current stock price divided by the company's book value (total assets less total liabilities). Growth stocks typically exhibit higher P/E and P/B ratios, while the ratios for value stocks are almost always lower. The bottom line is that the current price of a stock is far less informative than its relationship to the measurable value of the company.
Given all that's been said, one might suspect that growth stocks are expensive and value stocks are cheap. This generally may be the case, but not necessarily. Consider a company with desirable products and reliable markets whose share price is depressed because conflict among management has hindered productivity. Even at its lower share price, this is not a true value stock because the company is not fundamentally healthy and its share price is unlikely to recover. Growth stocks can pose similar challenges to the style-minded investor, as they can sometimes sell quite cheap relative to their earnings potential. The key to successfully navigating these anomalies is to do research, recognize good investments when they come along and not miss out on opportunities because of style labels.
Sometimes a growth stock can masquerade as a value stock. For example, say a relatively new company has developed a promising piece of technology. The company's stock may be undervalued for a time because investors are wary of the company's short track record, or perhaps they simply haven't yet recognized the growth potential of the new technology.
Variations on Growth and Value
Value investors use methodologies based on the original teachings of Benjamin Graham and David Dodd. Graham and Dodd were professors at Columbia Business School who pioneered value investing in the 1920s. Today, some investors focus on absolute value (as measured by P/E and P/B ratios), while others look for relative value. A relative value approach may compare a current indicator like the P/E ratio to the company's own historical P/E ratios, or to the ratios of other companies in the same industry. Using a relative value approach, it is even possible to find growth stocks that are relatively undervalued versus their peers.
There are also different approaches to growth investing. The core growth philosophy argues that a high stock price does not matter if the company's growth prospects are sufficient. Some investors, however, take the view that a growth stock is only worth buying if the price is reasonable. This approach, known as Growth at a Reasonable Price (GARP), is essentially a hybrid of growth and value investing.
Selecting stocks based on a single measure, such as its P/E ratio, can be very risky. Most large-scale investors and fund managers of both styles rely heavily on fundamental research to uncover strong companies that represent good investments.
Helping Your Portfolio Go With the Flow
So which style is right for your portfolio? The answer is: both. Value and growth stock performance moves in phases because the business cycle affects growth stocks and sectors differently than it would their value-oriented counterparts. Since it is very difficult to predict when the phase will change, it is important to own both value and growth stocks in a diversified portfolio. Diversifying across equity styles may also help to mitigate some of the risk of investing in either of these asset classes in isolation.
Historically, growth stocks have performed better when the economy was prospering, while value stocks tended to take the lead when the economy was in the midst of, or climbing out of, a recession. An example of this can be seen in the chart below, during the years preceding the bear market of the early 2000s. Although growth stocks were strong from 1995 to 1999 and provided superior returns in both 1998 and 1999, they plunged with the bear market in early 2000. Value stocks took a beating as well, but to a lesser degree as compared to growth investments.
If you look at the chart as a whole, though, you will notice that growth and value have each taken the lead at different points in time, but their overall performance has been relatively equal for the past 21 years.
Growth vs. Value Over the Years
Growth and value stocks have taken turns leading the market, so long-term investors may benefit from owning both.
Sources: BlackRock; Informa Investment Solutions. For illustrative purposes only and does not represent any particular investment. Performance does not reflect any fees, expenses or taxes. It is not possible to invest directly in an index. Past performance is no guarantee of future results. Large-Cap Value is represented by the Russell 1000 Value Index. Large-Cap Growth is represented by the Russell 1000 Growth Index. The Russell 1000 Index consists of the largest 1,000 companies in the Russell 3000 Index. The Russell 3000 Index is composed of 3,000 large US companies ranked by market capitalization, representing approximately 98% of the US equity market. The Russell 1000 Growth Index is a subset of the Russell 1000 Index that consists of those Russell 1000 securities with higher price-to-book ratios and higher forecasted growth rates. The Russell 1000 Value Index is a subset of the Russell 1000 Index that consists of those Russell 1000 securities with lower price-to-book ratios and lower forecasted growth rates. The S&P 500 Index is an unmanaged index that consists of the common stocks of 500 large-capitalization companies, within various industrial sectors, most of which are listed on the New York Stock Exchange.
Growth and Value Mutual Funds
Since even the professionals can't agree on hard-and-fast guidelines to identify growth versus value stocks, it can be especially difficult for an individual investor to achieve a balanced portfolio with adequate exposure to the two styles. One excellent way to achieve such diversification is by investing in growth- and value-styled mutual funds. Fund managers have extensive research capabilities, and the size of a mutual fund allows it to hold a more diversified group of stocks than an individual can usually afford. BlackRock offers growth and value fund options diversified among large and small caps, and even international stocks.
The most important thing is to be sure you know how a fund invests before you invest. Ask for a prospectus and read it. If you have questions, and you probably will, call your financial professional or the fund company to get answers.
*S&P US Style Indices Index Methodology, April 2006, pg. 7.
This material is provided as an educational tool and is not meant as an investment recommendation. The information contained in this material is in part derived from third-party sources deemed reliable, but BlackRock does not guarantee the completeness or accuracy of the information.
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Prepared by BlackRock Investments, LLC, member FINRA.