Key Takeaways:
Wall Street has proven to be a great long-term wealth-building vehicle. The S&P 500, for example, has rewarded patient investors with an annual average return of 13.6% in the past 10 years. However, it is worth noting that not all stocks that helped investors beat the market in that time are created equal. Many of the most desirable stocks may look the same on their surface, but a closer look at their fundamentals will reveal most equities fall under two categories: growth and value stocks. These equities have demonstrated an increased propensity for creating wealth over time, which begs the question: Which types of stocks are better for today’s investors? More importantly, who wins the ongoing growth vs. value stocks debate? The following will discuss value vs. growth investing and which strategy may be suited for your specific goals.
What Are Growth Stocks?
As their names suggest, growth stocks represent companies whose prerogative is to grow at a fast pace. By that definition, however, every company listed on the stock market could conceivably adopt the growth stock moniker. Fortunately, there are more specific indicators to help us differentiate growth stocks from undervalued stocks.
Growth stocks are traditionally smaller companies with aspirations of becoming leaders in their respective industries. In doing so, growth stocks tend to trade immediate profits for accumulating revenue. More specifically, growth companies prioritize generating the most income possible over retaining profits on their balance sheets. That means most growth companies are perfectly comfortable putting money back into the business to expand operations.
In the short term, the vast majority of growth stocks aren’t even profitable because of their willingness to fund future expansion. It isn’t until the businesses mature enough to turn their previous investments into actual profits that they start to shed the idea that they are still growing. Consequently, once growth stocks turn their attention towards maximizing profits, they may no longer prioritize growth; they may be more content maintaining the status quo, which leads directly into the growth vs. value stocks debate everyone is interested in settling.
Understanding Growth Investing
Investors covet true growth stocks with long-term strategies. If for nothing else, building a position in a growth stock while it’s still in its growth phase has the potential to create immense wealth, given that the company has years to reinvest revenue into a promising business model.
Growth stocks tend to trade at higher multiples than their less promising competitors. The untapped potential of a promising growth stock increases its perceived value in the eyes of growth-minded investors, which ultimately leads to more buying and stock price increases. As a result, great stocks often get caught in a positive feedback loop. Investor sentiment will oftentimes increase the stock’s price-to-earnings (P/E) ratio, which suggests the company’s growth rate will outpace the broader market.
The said, not all growth stocks live up to their potential. In fact, only a small minority of stocks will actually outpace the growth trends set by the overall market. Therefore, it is important to understand growth investing to pick the right stocks. Investors can’t simply evaluate a growth stock based on its P/E ratio; some don’t even have earnings. Instead, investors need to account for every metric, some of which are objective and others that are subjective.
Investors have developed several ways to uncover growth stocks, not the least of which account for recurring revenue, great management with skin in the game, long-term tailwinds, respectable balance sheets, and–perhaps more than anything else–a disruptive idea. There are several ways to differentiate great growth stocks from the weeds, but the best place to start is with an idea that brings something unique and necessary to the market.
Only once all of the variables are accounted for will investors be able to get in on the ground floor of truly great growth stocks.
Example Of A Growth Stock
There may be no better example of a growth stock than Amazon (NASDAQ: AMZN). One of the world’s largest companies comes from humble beginnings. Founded in 1994, Amazon started as a modest online bookstore. However, instead of pocketing profits, the founder spent nearly three decades reinvesting revenues into the company, ultimately creating the largest e-commerce business on the planet. Today, Amazon has a market cap of $1.5 trillion, and there’s nothing to suggest the company is done growing. To this day, Amazon reinvests its revenue into profit-generating ideas down the road. When all is said and done, Amazon is very comfortable inviting in its own future, making it the ultimate growth stock.
Despite Amazon’s unparalleled success, it’s not the only growth stock on Wall Street (far from it). There are countless up-and-coming businesses with limitless growth potential; the trick is identifying them early. Again, there’s no proven way to find the next Amazon, but there are telltale signs to keep in mind. Companies with a good product and superior management team are a good place to start. From there, investors will want to dig into the financials a little more. While they may have to put up with a high P/E ratio, they should look for companies with attractive financials and a willingness to forego profits by reinvesting revenue; that’s where true growth resides.
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What Are Value Stocks?
Value stocks are equities which are currently inexpensive, relative to their earnings and long-term growth potential. In identifying value stocks, investors typically look for many of their telltale signs, which include, but are not limited to:
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Business models which have already had the opportunity to grow and mature
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Slow yet predictable and steady growth rates
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Stable revenues and earnings reports
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Clear balance sheets which allow room for increasing profits
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Affordable P/E ratios
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Clear signs the company has shifted from a growth mentality to more of a maintenance mentality
Understanding Value Investing
The fundamental concepts behind value investing are reliant on identifying and investing in under-appreciated equities. That said, the definition of under-appreciated equities will most likely vary from investor to investor. If, for nothing else, there’s a lot of subjective research which goes into finding what many would call a value stock. What one investor deems a value, another may write-off as a value trap (some stocks look like a value for a reason).
While broad definitions will vary, most investors can agree value investing doesn’t only account for long-term potential but also that the current valuation is attractive, relative to where the stock resided in the past. Value investors inherently seek out stocks and equities which may currently be acquired at a low cost.
Investors will often use metrics like the price-to-earnings ratio to find and identify value stocks. By comparing a company’s share price to its earnings per share (EPS), investors will gain insight into a price multiple that can tell them whether a stock represents a value or not. Of course, the P/E ratio is only part of the equation, but it’s a good place to start. Following the valuation, investors will then need to determine the viability of the company itself. Sometimes cheap price multiples can be a trap. Therefore, investors will need to back up the P/E ratio with other positive indicators: a viable business model, good product, clean balance sheet, superior ownership, and anything else representative of a good company.
Once value stocks are identified, expectations must be brought inline. Specifically, value investors will favor slow and steady income over high-flying growth stocks’ volatility. While value investing may not have the upside of many growth stocks, returns are typically more predictable and steady.
Example Of A Value Stock
The unique marketplace leftover in the wake of the Coronavirus has created an unprecedented amount of what many people would call value stocks. Fear and uncertainty onset by the pandemic more than a year ago forced many investors to sell out of traditionally great companies. The transition to a work-from-home economy suppressed many high-end businesses, but the light at the end of the tunnel is growing. The economy is on the verge of reopening, and many stocks are expected to benefit from a tailwind of positive trends. One stock, in particular, appears to be a great value play at the moment: The Boeing Company (NYSE: BA). No growth vs. value stocks debate would be complete without at least bringing up Boeing.
Boeing has set the bar for value stocks in today’s market. In doing so, however, Boeing took a big hit when the pandemic shut down the economy in March of 2020. The aviation industry leader lost revenue from every branch, as flights and tourism were all but eliminated. Every revenue stream was cut off almost overnight, and Boeing’s stock dropped dramatically. While it has improved as the economy looks closer to reopening, it’s still far from its 2020 peak. At the moment, Boeing represents a value. Few stocks are more likely to benefit from the reopening than Boeing, and the momentum it receives will likely increase share prices steadily over time.
Are Value Stocks Riskier Than Growth Stocks?
Value stocks are no riskier than their growth counterparts. In fact, the entire stock market is full of risk, and neither of these commodities is the exception. To be clear, there’s risk to be found in both growth and value stocks. However, most growth stocks’ unproven nature and the increasingly competitive landscape of the twenty-first century ultimately expose growth stocks to more risk. Value stocks, on the other hand, are typically more established with better balance sheets. Value stocks are also fairly synonymous with stable revenues and steady growth rates. At the very least, value stocks have an established foundation to work off, which mitigates risk more than unproven growth stocks.
Value Vs. Growth Stocks: Which Is Better?
The “value vs. growth stock” debate will continue forever, as there is no definitive answer to the age-old question. When all is said and done, both growth and value stocks can make great additions to any portfolio; there’s no need for investors to choose between the two. That said, each equity may play a different role in a particular investment strategy. Then, and only then, will the differences between growth and value stocks play for or against a particular investor. In other words, investors will favor one or the other depending on their particular strategy.
Investors who fit into the following categories may want to prioritize growth stocks:
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You favor long-term growth over immediate income
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You can stomach the volatility typically associated with growth stocks
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You have faith in your ability to pick a truly great, market-beating growth stock
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You don’t need the money for a minimum of five years
Investors who fit into the following categories may want to prioritize value stocks:
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You are more interested in immediate income, whether it’s in the form of dividends or value
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You prefer more stable stock valuations than the volatility of most growth stocks
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You can identify value traps that lure in unsuspecting investors (sometimes stocks are low for a reason)
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You are looking for slow and steady gains
To be clear, there’s no reason investors couldn’t decide to invest in both growth and value stocks. In fact, it would be hard to argue against owning both in a diversified portfolio. However, investors looking to invest a particular way will want to choose their stocks based on their own financial goals. Hopefully, this helps you better understand the value vs. growth debate.
Summary
The growth vs. value stocks debate has caused a large division amongst specialty investors. At the very least, a large contingent of investors will suggest there’s no other way to invest than in growth stocks. Consequently, for every growth investor, there’s a value equivalent. Both strategies have proven to work well, which is why both sides have such big proponents. That said, there’s absolutely no reason investors have to choose one strategy. It is entirely possible to invest in both growth stocks and value stocks, ultimately ridding yourself of the headaches that come with having to debate growth vs. value stocks. Investing in both types of stocks could diversify any portfolio while simultaneously maximizing upside and mitigating risk.
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