Growth Investing vs Value Investing: Which is Better?
Growth and value investing are two distinct approaches to investing in the market. Each of these methods of investing follows different investment strategies, have a band of loyal followers and have their own advantages and disadvantages.
Value investing refers to an investment strategy wherein stocks that appear to be trading for less than their intrinsic or book value are carefully chosen for investment. Value stocks are the stocks of companies that are undervalued in the market relative to the company’s performance. They refer to company stocks whose share price does not yet reflect the potential for growth these companies display. They might have good revenue growth, may display profitability and a clear pipeline, and may even be debt-free.
These stocks thus have a low price in the equity market compared to peers in the same industry. Value stocks are also associated with a low price-to-earnings ratio, low price to book value ratio, and a high dividend yield. A value stock may be suffering low valuations due to adverse events in the industry or other external factors. Hence, traders value such stocks at a bargain price.
Value stocks could be undervalued due to numerous reasons.
- There could be a temporary dip in the market due to which investors start panic selling.
- The volatility in the market due to herd mentality may lead to the undervaluation of good stocks.
- Investors may sometimes ignore stocks that don’t look glamorous, aren’t popular, and focus more on well-known stocks that belong to corporate giants.
Growth investing, on the other hand, is an investment strategy focused on increasing an investor’s capital. Growth stocks are the opposite of value stocks. Growth stocks trade at high prices since investors believe that they will eventually outperform benchmark indices and possess a potential for high growth in the future. These companies are expected to beat market levels in sales and revenue growth which can lead to a spike in demand for these stocks over time.
Growth stocks generally reserve dividends rather than distribute them to the shareholders. They tend to retain all their profits and re-invest them in profit-building activities such as in research & development and in purchasing assets. The common characteristics of growth stocks are high price-to-earnings ratios, low dividend yields, and high price-to-book values. Shares of most small-cap companies may be termed growth stocks since they aggressively focus on growth, possess unique patents or technologies that may catapult them to the bigger leagues.
Since value and growth stocks are in stark contrast with each other, investors have different strategies and expectations before investing in either of them. If you’re unsure of the most suitable investing strategies for your needs, consult a financial advisor to assess your options.
Let us look at both types of approaches to investing in detail:
Growth investing
Investors who wish to invest for the purpose of quick capital appreciation, irrespective of the inherent risk it may entail, look for stocks that are affordable and show rising price trends. For example, a company’s stock could be $50 per share at the present time. Assuming the company has the potential to grow, it can lead to the price of the company’s stock rising. The investors firmly believe that the company will experience increased growth momentum, and thus, experience a substantial rise in the market price. Therefore, their probability of making profits majorly relies on the company fulfilling their expectations.
Sometimes, the growth stocks receive expensive valuations due to the momentum push. Investors often end up piling on these stocks due to irrational profit expectations from the stock. They may ignore the company’s financial statements and fundamental ratios and instead follow herd behavior and have unrealistic expectations. In case if the company underperforms, the stock price can plunge significantly resulting in reduced stock valuations.
Growth investing carries a high risk and does not generally offer dividends to shareholders. In addition, the stocks are moderately expensive and have a significant risk in case a company underperforms. The only way an investor can make profits is if the corporation manages to fulfill its objectives. Growth stocks are also prone to price swings caused by changes in market sentiments.
Value investing
Value investors conduct an in-depth study to analyze the performance of a company. They evaluate various financial metrics such as revenue, EBITDA, the company’s business model, sales strategies, competitive advantage, brand reputation, and the target market. After analyzing all possible metrics, value investors try to predict an appropriate valuation for the stock that may not be reflected by the market forces just yet.
Value investing involves predicting the price of an undervalued stock to reach its actual potential in the near future. The basic idea behind value investment strategy is to buy a high-value stock at a discounted price that may deliver profits as the market grows. Investors hope to capitalize on market inefficiencies.
Value investing vs growth investing
A few of America’s top investors including Warren Buffet, Ben Graham, and Charlie Munger are all value investors. Other wealthy investors like Bill Ackman and Jeff Bezos have traditionally preferred investing in growth stocks.
Both, growth and value investing may seem different but they share uncanny similarities. The basic premise behind both strategies is to buy a stock that is set to be priced worth more in the coming future.
One difference between the two is the fact that growth stocks may flourish when the market sentiments are positive due to the indices aggressively moving forward. Value stocks, on the other hand, flourish when the market faces uncertainty and the investors are scared. This happens because value stocks have better authority and give out regular dividends. Hence, they remain relatively stable during market downturns. Whereas growth stocks may crash during market fluctuations.
The two investment styles also differ with one another due to biases. A stock that is labeled as a valued stock is considered to have no immediate earnings potential but rather a delayed gratification far in the future. This often keeps it out of the portfolios of regular investors who disregard it for investment. Growth stocks are more commonly traded, as there is the visibility of their price performance on a daily basis.
Which strategy is better: growth investing or value investing?
Each investor has their own separate investment strategy which is created after factoring in several factors like investment horizon, capital, risk appetite, and goals. An individual’s investment strategies are also influenced by changes in the market sentiment and the economy. Growth stocks outshine value stocks when the central bank lowers interest rates, whereas investors may flock to value stocks when the interest rates are reduced by commercial banks. In recent times, growth stocks have had a better run than value stocks. Nevertheless, value stocks are known to perform well in the long-term.
Growth stocks have been under the spotlight in the market because investors have become highly skeptical about the economy’s growth, which may lead to a sharp correction in their stock prices. Hence, investors prefer to invest in stocks that can weather a slow growth rate and disinflationary climate to increase earnings.For example, FAANG stocks traded at a price-to-earnings ratio of 24 during the end of 2021, whereas the S&P 500’s highest P/E ratio was 16.
During the period of revival after the pandemic, technology and communication stocks dominated the equity markets in America. In contrast, the energy and finance sectors that represented value stocks were briefly struggling. The uncertainty associated with the global pandemic increased the disparity between the valuation of the sectors.
Although growth stocks have their own set of benefits in the short run, value investing tends to generate increased gains in the long run. In a shorter time period, growth stocks may outperform value stocks by a slight margin. According to data released by Nobel laureates Eugene Fama and Kenneth French, value stocks have shown greater returns than growth stocks 93% of the time between the years 1927 to 2019.
Value and growth investing strategies both share the risk of falling into the value trap. Value investors might invest their capital in an undervalued stock for an extended period even when the stock underperforms continuously hoping for improved market performance. This phenomenon is referred to as the value trap. In the case of growth investors, they might invest heavily in expensive growth stocks and face losses, if the stock fails to reach the expected level of earnings growth.
To conclude
The key to good returns is diversification; thus an investor who adds both growth and value stocks in their portfolio can generate significant returns. The debate between investing in value or growth stocks is never-ending as both investing strategies have their own set of pros and cons. Growth stocks are suited for short-term returns, whereas value stocks are best if you are looking to invest for a longer time horizon. However, the investor needs to ensure that they take adequate measures to avoid falling in the value trap. Therefore, carrying out systematic research and analysis on stocks is crucial for making the right investment decision. You may want to reach out to your trusted financial advisor or investment advisor before investing in the stock market.
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