Among the seemingly endless ways to categorize and label stocks, the most basic way is between value stocks and growth stocks.
These are generalizations, of course, but the differences do matter. And understanding the idea of value stocks and growth stocks can help your portfolio work better for you.
Value Stocks: Well Worth Their Price
Value stocks tend to be shares in companies that have more mature businesses. Their days of outsized growth potential are long gone. As a result, value stocks trade at lower multiples than growth stocks.
Since these tend to be older businesses whose exciting days are behind them, it’s easier for the market to underestimate their growth potential. Theoretically, this makes value stocks mispriced.
As an aside, when we say a stock is “cheap,” that’s not a reflection of the per-share price. A $100 stock can be cheap at the same time a $10 stock is expensive. Rather, it reflects whether the stock is worth that price using one or more valuation multiples, such as the price-to-earnings ratio. If a stock trades at a P/E that doesn’t adequately account for its earnings — past or future — it is said to be “cheap.”
The basic idea is that if a stock is cheap, an efficient market will eventually catch on to the fact and the share price will go up.
In addition to trading at lower valuations, value stocks tend to return more cash to shareholders in the form of dividends (cash paid by companies directly to shareholders) and share repurchase programs. The company behind a growth stock is supposed to reinvest its profits in the business. Companies associated with value stocks, however, have more profit than they have ideas of where to put it. Growth stocks can pay dividends, but it’s the exception, not the rule.
Value stocks also tend to be less risky than growth stocks. They don’t rise as much as the S&P 500 market in up markets, but they hold up better when everything is selling off.
Cheap valuations, dividends and low volatility make value stocks a good place to look for defensive names.
Valuation is somewhat in the eyes of the beholder, but some examples of value stocks would include Exxon Mobil Corporation (NYSE:XOM), Johnson & Johnson (NYSE:JNJ) or General Electric Company (NYSE:GE).
Growth Stocks: More Risk but More Reward
Growth stocks are more expensive than value stocks. That’s because most investors want stocks whose prices are going to rise and are willing to pay a premium to get it. This often results in high P/E multiples that can scare off more conservative investors.
Proponents of growth stocks have no trouble with those high P/E’s because these companies are investing in the future. The thinking goes that a growth company is putting its earnings back into the business or booking net losses, so price-to-earnings measures aren’t as relevant.
Additionally, growth stocks generally don’t pay dividends and they tend to be more volatile. That means they are riskier. They outperform the S&P 500 when it is in a bull market, but also sell off more steeply in a bear market. Examples of growth stocks would include Amazon.com, Inc. (NASDAQ:AMZN), Facebook Inc (NASDAQ:FB) and Netflix, Inc. (NASDAQ:NFLX).
Lastly, there’s something called “growth at a reasonable price,” or GARP. GARP stocks are said to have better-than-average growth prospects but don’t sport too-high multiples. They offer a little bit of value and growth.
Keep in mind that growth and value stocks are cyclical. When times are good, the market tends to favor growth. When the economy is sluggish or slowing down, investors tend to hide in value.
Which One to Choose
When talking about value vs. growth, what we’re really talking about is risk vs. reward. Growth offers greater potential upside, but it also comes with a greater chance of loss. Value is stodgier but steadier.
If you’re saving for retirement — and you should be — your returns are measured in decades. That’s where the value in value stocks shines through. At the same time, however, there are bound to be a number of bull markets going forward where growth stocks will generate superior returns.
Younger investors with longer time frames may want to skew their portfolios in favor of growth. That’s because they have plenty of time to recoup any losses from the inevitable market downturns. By the same token, older folks who care most about capital preservation should favor value holdings.
But the bottom line is that most investors should own both styles of stock. Just as a portfolio should be diversified between stocks and bonds, a blend of value stocks and growth stocks is usually the way to go.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.