There are two fundamental styles of investing in stocks. One is growth and the other is value. All investors want to make the right choice when investing their money or their client’s money, and knowing when and how to invest in each style is key. If you are curious about the details of growth vs. value, below will outline the definitions of each, the pros and cons of each, and how Bill Few Associates approaches their stock selection process.
Growth investors look for companies forecasted to have above-average growth in sales and earnings. These companies tend to have high price-to-earnings (P/E) ratios and low dividend yields. Dividends are low or non-existent because management reinvests earnings back into the business instead of paying it out as income to investors. “Growth stocks” use innovation and technology to take large bites of market share from competitors. The ultimate goal for the growth investor is to buy exciting companies with potential for rapid expansion.
Value investors look for companies they believe to be priced at a discount to an intrinsic value based on fundamentals of the business. These companies are typically established players in mature industries. They generate strong cash flows from core operations and pay out higher dividend yields than the broad market. Classic “value stocks” are in sectors like industrials, utilities, banks, and consumer staples. The ultimate goal for the value investor is to find hidden gems the market is discounting in the short term whose value will be recognized over time. Warren Buffett crystalized this idea when he said, “If the business does well, the stock eventually follows.”
Which is Best?
Historically, value outperforms growth over the full economic cycle, but growth can have stellar performance during expansions. This means macroeconomic trends have a great impact on which investment style is in or out of favor.
Growth stocks, in general, have the potential to perform better when interest rates are falling and corporate earnings are rising. They thrive when the market has strong upward momentum and are typically led by tech companies. On the other hand, they may also be the first to be punished when the economy is cooling. It is possible for growth-oriented companies to be insulated from economic headwinds as long as they continue to meet their high expectations. They can, however, quickly suffer losses the moment they fail to deliver on those expectations.
Value investing tends to outperform during periods of volatility and bear markets. This is because investors get more opportunities to buy stocks at cheap prices and value stocks act as a better cushion against losses during economic headwinds. These mature industries may survive well during recessions and spring back during the early stages of economic recovery, but they are more likely to lag behind high momentum growth stocks in a sustained bull market.
In simple terms, value investors make money by buying low and selling high while collecting large dividends in between. Growth investors make money by buying high and selling higher, while trying to avoid holding the hot potato when the music stops.
What are the Risks in Growth and Value Investing?
Benjamin Graham, widely known as the father of value investing, wrote “you must deliberately protect yourself against serious losses” in his book The Intelligent Investor. Warren Buffet echoed this sentiment on losses when he said, “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” Growth and value investing each have unique pitfalls that can result in steep losses.
On the growth side, we don’t want to be vulnerable to catastrophic losses from holding stocks with unreasonably high P/E multiples. These stock prices can collapse from poor earnings performance or a common market correction. This famously happened when the internet bubble burst as speculative enthusiasm drove prices to unsustainable levels. Investors leaned on hope that new technologies would be transformative to society rather than focusing on trends related to revenue, profits and cash flow generation. These investors learned a hard lesson which was described by Burton Malkiel in A Random Walk Down Wall Street: “The key to investing is not how much an industry will affect society or even how much it will grow, but rather its ability to make and sustain profits.” We prefer to look for growth at a reasonable price as opposed to momentum investors who will buy growth regardless of price.
On the value side, we want to avoid catastrophic losses by dodging value traps. Value traps are companies that look like a bargain but get trapped in a perpetual state of “the other shoe dropping.” Each new price drop looks like an attractive entry point as P/E ratios hit historic lows. Management teams tempt nervous investors with new initiatives to restructure, cut costs and boost sales. The stock looks like it could be at the bottom, poised to bounce back, but instead, it continues to plummet. Investors eventually realize the company is not on sale but that it is impaired in a fundamental way.
What is Our Investment Style?
Instead of attempting to predict macroeconomic trends and make concentrated style bets, we prefer to blend both styles into our stock portfolio strategy. We combine elements of growth and value in order to preserve capital in challenging market periods and capture upside in bull markets. This helps us smooth out returns over the long term and reduce portfolio risk through diversification. A common theme between the high P/E growth stocks and value traps is that investors place high hopes for a dramatic improvement in performance that is not supported by the fundamentals of the business. I once had a boss who said, “When it comes to planning your retirement, hope is not a strategy.” By maintaining a balanced approach and guarding against the risk of excessive losses, we do not have to depend on hope. As the market ebbs and flows between growth and value, we can take its challenges head-on and look for new opportunities.
At Bill Few Associates, our team of dedicated investment management professionals focus — day in and day out — on making, monitoring, and managing portfolios that are responsible, reliable, and right for you. Have questions about your portfolio options? We can help. Contact us today.