Value and growth are two approaches or “styles” of stock investing. Value stocks are companies that have fallen out of favor and are undervalued relative to their actual worth. Growth stocks are companies that demonstrate strong potential to increase revenue or earnings.
Both styles have pros and cons. In value investing, investors can buy a company with strong fundamentals at a bargain. The risk is that investors fall into a “value trap”–companies that appear cheap but don’t have good businesses and are trading at a discount for a reason.
With growth stocks, investors can bet on a promising company with a product or service that can help it beat competitors or even disrupt an entire industry. The con is that investors often encounter high valuations. While some investors argue growth stocks are worth paying more for, the risk is that too much exuberance has pushed some names to become overvalued.
In recent years, growth stocks have trounced value ones. Some market observers say this is because economic growth has been anemic since the 2008-2009 U.S. recession, causing investors to pay up for growth. In 2020 however, the potential for an economic rebound after the Covid-19 pandemic has some value investors hopeful there will be a rotation back into their stocks.
What Are Value Stocks?
In value investing, investors hunt for companies that aren’t getting a fair valuation in the market. Value stocks are often considered cheap and unfashionable. The economist Benjamin Graham, who wrote the book The Intelligent Investor, is widely considered the “father of value investing.” In more recent times, Warren Buffett is one of the most famous value investors.
Value investors typically evaluate a stock by going through its quarterly or annual financial statements and comparing the figures to the price it’s getting in the market. They then use valuation metrics to decide whether the company is cheap relative to its own history of trading, the rest of its industry, or a benchmark measure like the S&P 500 Index.
It’s important to remember that a value investor is still looking for a quality stock. The hope is that the investor is buying the stock while it is in a lull, and then the market will correct the value of its shares, lifting them to their “intrinsic” or true value.
There can be a variety of reasons why a company may be underpriced:
1. Cyclical stocks: The company is cyclical, or tied to economic growth. Its stock has some strong fundamentals but may be experiencing a dip because of a downturn causing fluctuations in the market. However, it still has the potential to bounce back once a recovery is underway.
2. Sector problems: A company might be a quality stock even if the rest of its sector is out of favor. For instance, a pharmaceutical company may have an important drug in its pipeline, even as the rest of the healthcare sector is unloved by investors.
3. Behavioral Finance: Stock investors may be exhibiting signs of herd mentality, congregating around a few names and generally overlooking potential value names.
4. Bad press: A company may have experienced a bout of bad publicity, but the reason may be more short-term or not business related. Its shares may experience a resurgence in the aftermath of the bad press.
5. Simply overlooked: A company may have shifted its focus or added a new business line. The market may need more time before recognizing the potential or results of this change. A company may also be relatively new and not have much name recognition yet.
Examples of Value Stocks
Here’s the sector breakdown in the S&P 500 Value Index as of Nov. 30, 2020.
The biggest components of the measure as of Nov. 30, 2020 were Berkshire Hathaway B shares, Unitedhealth Group Inc., Verizon Communications, Johnson & Johnson, Bank of America Corp., Pfizer Inc., Walmart Inc., AT&T Inc, JPMorgan Chase & Co., and Cisco Systems Inc.
Determining whether a company is undervalued however is often subjective. For instance, some investors say traditional energy companies are currently inexpensive. Others argue that this is warranted due to an oversupply of oil and gas. Others also say that the energy industry faces structural challenges, such as the environmental concerns among individuals who may turn to investing in green stocks instead.
Valuation Metrics For Value Stocks
Below are two traditional valuation metrics that value investors often use:
Price-to-earnings (PE) ratio = price per share/earnings per share
For Benjamin Graham followers, it is important in value investing that a company’s PE ratio be 40% less than the stock’s highest PE in the previous five years.
Investors can use either trailing or forward earnings to determine the denominator in a PE ratio. Trailing earnings are the profits recorded by the company in the past year, while forward earnings are the profits the company estimates it’ll make in the next 12 months.
Price-to-book (P/B) ratio = price per share/book value per share
Book value is the total assets on a company’s balance sheet minus its liabilities. It’s an estimate of the company value if it were to be liquidated. Benjamin Graham considered value stocks as needing to have a price-to-book ratio of less than 1.0.
What Are Growth Stocks?
Growth stocks are companies that have shown the potential to significantly boost their earnings or sales, usually a faster rate than the market average. These companies typically do not pay dividends to their investors since they’re often expected to invest the majority of their earnings back into the businesses in order to continue expanding.
Another attribute growth investors may look for is a tendency to have a unique competitive advantage that would allow a business to outperform others in the same industry.
There is no set formula for finding a growth stock, but many investors look to industries that are expanding rapidly and developing new services and technologies. Technology is the most famous growth sector. For instance, venture capital funds, financing firms prevalent in Silicon Valley, are a type of growth investing for private companies.
Examples of Growth Stocks
While many investors consider technology stocks to be almost synonymous with growth, growth investing opportunities can be found in a variety of industries. Here’s a breakdown of sectors in the S&P 500 Growth Index as of Nov. 30, 2020.
Through the end of November 2020, the biggest stocks in the growth index were Apple Inc., Microsoft Corp., Amazon.com Inc., Facebook Inc., Alphabet Inc., the owner of Google, Visa Inc., Nvidia Corp., Mastercard Inc., and PayPal Holdings Inc.
Valuation Metrics For Growth Stocks
In growth investing, it’s less clearly defined what investors can look for in a stock. But here are two valuation metrics that growth investors may use:
Price-to-sales (P/S) ratio = price per share/sales per share
Investors may use a company’s sales because not all growth companies may be profitable. Using revenue also allows them to see how quickly they’re expanding without having to factor in costs.
Price-to-earnings-growth (PEG) ratio: PE ratio/projected earnings growth
Let’s say for instance a company’s PE ratio is 15. Meanwhile, its projected earnings growth for 2020 versus 2019 is 10%. Then its PEG ratio would be 1.5. A PEG of 1 or greater typically means investors are overvaluing the company, while a ratio less than 1 may mean it’s relatively cheap.
The PEG ratio is often used by investors who want to consider both value and growth investing. It’s also a popular metric for investors who practice GARP, or “Growth at a Reasonable Value”–an investing style made famous by Fidelity manager Peter Lynch.
Why Value Stocks Have Underperformed?
Economists Eugene Fama and Kenneth French published a famous study in 1992 showing that value stocks, those with low price-to-book ratios, rewarded investors over time. But the past decade or so has been brutal for value companies. Some business publications have noted that the performance gap is the highest it’s been in at least 25 years.
In the decade through November 2020, the annualized total return by the S&P 500 value index was 11%, while the return from its growth counterpart was 17%. In 2020, the value measure returned minus 2.1% through Nov. 30, while the growth measure surged 28%.
Market experts have debated multiple reasons why value has struggled:
1. Slow growth: The pace of expansion in the global economy broadly has been slow since the 2008 financial crisis, causing growth investing opportunities to become scarce and investors to bid up their prices.
2. Low yields: On a related note, the Federal Reserve has responded to anemic growth by keeping interest rates low. That’s depressed bond yields, which subsequently pushes investors into expensive, high-growth stocks.
3. Valuation problem: A third could be that valuation metrics for what’s cheap are outdated. Take price-to-book value, the basis of the Fama-French study. Some critics have pointed to how the metric doesn’t track intangible assets like brands and intellectual property, which have become increasingly important to a company’s worth these days.
Can Growth Continue to Beat Value?
The decade of underperformance coupled with dismal returns recently has caused some value investing firms to shutter. Some investors have been saying for years the market is due for a reversal, which is what happened after the stock market crash in the early 2000s.
Others argue that growth’s strength has really been driven by momentum–a type of trend trading–in a handful of stocks. Investors have heavily favored in recent years the so-called FAANG stocks–Facebook, Amazon.com, Apple, Netflix, Alphabet’s Google. Some investors argue that their high valuations can eventually drive some investors away.
Some market observers point to the regulatory landscape as a reason for value’s underperformance. Financial stocks, often found in the value category, have been subject to regulation in the decade since the financial crisis. Meanwhile, technology stocks have been under less oversight. There could be signs that’s changing however, such as the Justice Department’s lawsuit against Google in 2020 alleging anticompetitive practices.
Value stocks are companies that are deemed to be “on sale” in the market, while growth stocks are those that investors buy for their potential to boost earnings or revenue at a rapid pace.
Value investors are often wary of “value traps”–scenarios where companies appear to be bargains but actually have weak fundamentals. Meanwhile, a risk for growth investors can be their companies becoming too expensive–a case that played out during the dot-com bubble.
Growth has vastly outperformed value over the past decade as the U.S. economy expanded at a tepid rate, spurring investors to pay rich valuations for scarce growth names. But some investors expect a rotation and value to make a comeback.
These two camps of investing have been a decades-long rivalry, but it’s possible for investors to use both approaches and add diversification to their portfolios. First-time stock pickers can hear out Warren Buffett’s perspective: “Growth and value investing are joined at the hip.”
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