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Talking Money: Growth vs. Value

By Paige Radke

Different styles of investing offer varying perspectives on how best to make money from the markets. Two main classes of stock investment styles are value and growth.

To foster financial literacy, the Talking Money feature covers common terms and concepts used in personal finance and investing. For more Talking Money terms, please click here.

Value and growth stocks often have advantages at different times. For example, during the dot-com bubble in the late ‘90s, investors made significant money from growth tech stocks. However, in the long run, value has tended to outperform growth.

Long-term investors do best by having exposure to both value and growth, regardless of where we are in the market cycle.

Value

Value investing focuses on the intrinsic value of a company, or the value of a business’ ongoing operations. Value investing looks at the value of companies’ underlying assets, annual earnings and flow of cash through the business as of this moment.

Value stocks carry lower-than-average price-earnings ratios and attract investors who expect the price to eventually reflect what they think the stock is worth.

Value stocks tend to have companies that pay dividends as an important source of return on the investments. Dividends also help investors evaluate the financial health of a company because although businesses have ways to manipulate their balance sheets, they need real cash on hand to pay out dividends.

A risk of value investing is wrongly assessing a company’s intrinsic value – overestimating when buying, underestimating when selling. Another risk is investing in a “value trap,”  when a stock is trading below the current intrinsic value, but the price never improves due to outside influences, such as increased competition or technological advances.

Examples of value stock companies include those in the industrial, financial and utilities sectors.

Growth

Growth investing focuses on the potential value of a company, or the value of the forecast growth of a business. Growth investing examines business models, business investments and sources of earnings growth in the future.

Growth stocks rarely pay dividends because such companies believe it is better to reinvest cash into the business to increase productivity and potentially generate higher future earnings. The investment returns for growth typically come from capital gains.

Growth companies typically have higher price-earnings ratios and appeal to investors willing to pay for a company whose intrinsic value is expected to grow over time.

The risks of growth investing include wrongly projecting how much earnings will expand. There is high uncertainty tied to investing in developing companies in such sectors as biomedical and pharmaceutical. Companies in growth industries have a greater probability of missing analyst earnings projections.

Among the sectors for growth investing are technology, healthcare, and consumer discretionary.

Growth Value comparison

Not one or the other

Studies show that over extended periods, value investing outperforms growth investing. Looking at 10-year spans since 1979, value stocks have outperformed growth stocks 73% of the time.

But due to the constantly changing nature of the economy, there are often shorter periods when one style of investing outperforms the other.

Value tends to produce higher returns during the initial phases of an economic recovery, when more companies are trading below their intrinsic value. More stocks are available at a discount and benefit as market prices tick upward.

Value also outperforms growth amid high GDP growth and high inflation, signifying that the market may be overheating. At that late stage in the cycle, businesses have increased capital expenditures and wages, primarily benefiting two of the largest value sectors – industrials and financials.

Learn more:
Investors and the business cycle, a Money Talk Video with Dave Sandstrom
Ask Money Talk: Value investing, with Brian Kilb
Balancing value and growth, a Money Talk Video with Brian Kilb
Talking Money: Growth investing, by Kyle Tetting
Talking Money: Value investing, by Debi Rybicki

Growth tends to outperform value in the middle stages of economic recovery, when economic growth is more subdued and the majority of value-oriented stocks are no longer seen as bargains. That is when more investors are willing to pay up for companies they expect to create future earnings growth beyond that of the current economic cycle.

Growth also generally has higher returns in times of low economic growth and low inflation, when analysts anticipate increased consumer spending. Growth stocks also sink like a rock when recessions fall.

Since it is difficult to determine when economic shifts will occur, it is in the long-term investor’s best interest to combine growth and value investments with occasional rebalancing. Balancing between value and growth allows long-term investors to benefit from each strategy regardless of the economic cycle, providing a smoother ride.

Paige Radke is an associate at Landaas & Company.

(initially posted Sept. 25, 2015)

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