Investing is often thought of as a big and complex topic. While there are parts of investing which can be quite hard to wrap your head around, those complexities aren’t necessary to understand if you want to be a good investor. You should, however, understand value vs growth investing and when to use each.
But if you want to be a good investor, the only thing you need to master is time.
Time is everything in investing. Sure, investing is all about picking the right stocks. But, picking the right stocks is a function of time. Specifically, time influences what type of stocks you should invest in.
And in this case, time is not the same as timing. In other words, when you buy a stock isn’t nearly as important as how long you plan to hold it for.
In the investment world, there are two types of stocks, and they are very different: value stocks and growth stocks. Time is everything in deciding how much of each you should own in your portfolio. If you master the concept of time, and therefore master the ability to optimally allocate between value vs growth stocks, you are well on your way to becoming a good investor, and will have portfolio that matches your personal goals.
What Are Growth Stocks?
Growth stocks aren’t that hard to define. Broadly speaking, they are stocks with big revenue and earnings growth potential.
Specifically, growth stocks are stocks that are growing profits more quickly than the market. This is best explained by example. Wall Street analysts go out and forecast revenue and earnings growth rates for companies of all shapes and sizes, and they do the same for the S&P 500 as a whole. Typically, these analysts make 5-year projections.
Right now, analysts are projecting roughly 16% earnings growth per year for the S&P 500 over the next 5 years. Any stock with a 5-year earnings growth rate above 16% would be considered a growth stock as opposed to a value stock.
What Are Value Stocks?
Value stocks are a bit trickier to define than growth stocks. Broadly speaking, when looking at value vs growth stocks, both are stocks that are priced attractively relative to their fundamentals and peers.
The specific definition of value stock can take many forms. Some investors classify value stocks as those with dividend yields that are bigger than the market yield. Other investors classify value stocks as those with price-to-earnings (P/E) multiples below the market average, or a price-to-earnings/growth (PEG) ratio below the market PEG ratio. But, the commonality between all these specific definitions is that value stocks are cheap relative to both fundamentals and peers.
Right now, the S&P 500 has a 1.8% dividend yield, trades at 17x forward earnings, and has a PEG ratio of 1. Thus, depending on your specific definition of value stocks, value stocks today should have a dividend yield greater than 1.8%, a forward multiple less than 17, and/or a PEG ratio below 1.
What Does Growth Investing Look Like?
Growth stocks are simultaneously exciting and dangerous. They can have huge moves to the upside because of the stock’s big growth potential. But, they can also have sharp swings to the downside because of big valuations.
Typically, growth stocks have big multiples, big growth rates, get lots of media coverage, and have great stories supporting them. For example, the widely followed and market-leading FANG stocks — Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and Google (NASDAQ:GOOG) — are all growth stocks. They are all projected to grow earnings by 20% or more over the next several years, and their forward multiples are all above 20x.
These stocks have been big winners over the past five years because the growth has been there to support the valuations. But, they are also subject to big drops at any point in time because of their super-charged valuations. For example, Facebook has plunged 25% over the past two months, while Netflix, Amazon, and Google have each had multiple 10%-plus drops over the past three years.
What Does Value Investing Look Like?
When looking at value vs growth investing, value stocks are simultaneously boring and safe. They don’t often have huge moves to the upside because there isn’t enough growth potential to warrant a big rally. But, they also normally don’t have sharp swings to the downside because the valuation is already depressed.
Typically, value stocks have low multiples, low growth rates, don’t get as much media coverage, and have rather boring stories supporting. For example, telecom giants AT&T (NYSE:T) and Verizon (NYSE:VZ) are poster-boys for value stocks because of their low multiple, low growth and big moat nature. Both have forward earnings multiple around 10x and both have dividend yields above 4%.
Neither of these stocks have really made a sustainable and meaningful move higher over the past five years because growth has been lacking to support a rally. But, they’ve also been relatively safe, and both have paid sizable dividends which have been far greater than the risk-free 10-Year Treasury Yield. Thus, while investors haven’t received capital gains, they have received a solid stream of income from the dividends.
When Should You Invest in Value vs Growth Stocks?
Let’s circle back to time. When it comes to picking value vs growth stocks, it is all about time.
All investors should own some value and some growth, but younger investors should have more growth holdings, while older investors should have more value holdings. In simple terms, younger investors can afford to take more risk because time is on their side, can absorb big near-term drops because they don’t need to withdraw investment money anytime soon, and can wait for a growth stock to grow into its valuation over a long period of time.
Older investors don’t have those luxuries. As such, older investors should take a more risk-adverse, time-sensitive approach to investing. That approach includes picking a lot of value stocks which provide a steady stream of income through a big dividend yield, have minimal near-term downside due to a depressed valuation, and don’t gyrate with every media headline.
Bottom Line on Value vs Growth Investing
Investing is all about timing, and a big part of timing is understanding where you are in life so that you can pick stocks that best match your personal goals.
Younger investors should put together retirement savings portfolios that emphasize growth, and balance that risk with some value stocks. Meanwhile, older investors should build a retirement savings portfolios that emphasizes value, and balance that stability with some growth stocks.
As of this writing, Luke Lango was long FB, AMZN, NFLX, GOOG, and T.