Should You Buy Value Stocks and Sell Growth Stocks in 2023?

After underperforming growth for years, value stocks finally had their time in the sun in 2022. The largest value-focused exchange traded fund (ETF) by net assets, the Vanguard Value ETF (VTV 0.74%), outperformed the Vanguard Growth ETF (VUG -2.25%) -- the largest growth ETF by net assets -- by a staggering 31 percentage-point margin in 2022. It was the largest outperformance of value over growth in over 20 years.

After value's dominant run in 2022, the Vanguard Growth ETF is now barely outperforming the Vanguard Value ETF over the last 10 years with a total return of 229% versus a 204% total return for the Vanguard Value ETF. 

This begs the question: Is growth going to continue outperforming value long-term? Or is it better to stick with value stocks instead of growth stocks? Let's find out.

Image source: Getty Images.

The benefits of value stocks

Blue chip value stocks tend to be well-known, industry-leading companies with strong balance sheets. This stability is ideally suited for investors more focused on capital preservation than capital appreciation.

These companies tend to be fairly valued or even trade at a discount relative to the market. They also tend to use excess free cash flow (FCF) to buy back their own stock and pay dividends. Using FCF in this manner leaves fewer funds to reinvest in the business, but there's only so much a company like Procter & Gamble can do to boost organic growth before it becomes excessive and borderline wasteful. For that reason, the value proposition for shareholders is more focused on consistency, boosting earnings per share by reducing the share count through buybacks, and providing passive income through dividends.

Here are the 10 largest components of the Vanguard Value ETF:

Data sources: Vanguard, YCharts. 

There's a good chance you will recognize most of the companies on this list. Given each company's track record for outlasting market downturns, as well as decades of stability, it's easier to sleep well at night holding these stocks during a bear market, because you know they have persevered through many before.

The benefits of growth stocks

When you hear the term growth stocks, you may think of smaller companies with the potential to compound several-fold over time. But large-cap growth stocks, like the 10 largest components of the Vanguard Growth ETF, are established, industry-leading companies that tend to pay small or no dividend(s), because they prefer to use FCF to reinvest in their businesses.

And while it's true that a company like Apple hasn't been around as long as Procter & Gamble, you could argue that Apple's products have become modern-day consumer staples. Or that Alphabet's Google search is the figurative fuel that powers the internet in the same way that ExxonMobil's oil and gas is literal fuel.

Data sources: Vanguard, YCharts.

You'll notice that many growth stocks tend to be in the technology, communications, and consumer discretionary sectors compared to the many consumer staples, financials, healthcare, and energy companies in the Vanguard Value ETF. You may also notice that the top-10 holdings of the value ETF only make up 22.3% of the fund. In comparison, the top 10 holdings of the growth ETF make up 46.6%, mainly because of the large market cap and multiple industry exposure of Apple, Microsoft, Alphabet, and Amazon.

Why growth is a better all-around buy

The argument for value over growth is predicated on the assumption that growth stocks are more expensive. But year after year of higher earnings from large-cap growth stocks paired with declining stock prices have made many once-expensive growth stocks now trade at more attractive valuations. Don't get me wrong, I think Procter & Gamble is one of the safest and most reliable companies to invest in, but it simply shouldn't be trading at a noticeable premium to cash cows like Alphabet, Apple, Microsoft, and even Tesla -- which all have far better long-term growth prospects.

The valuation argument alone makes growth a better buy than value. But I would also argue the rise of the risk-free rate paired with a decline in the yield of the Vanguard Value ETF makes the passive income component of value stocks less appealing.

Data by YCharts.

The Vanguard Value ETF has a dividend yield of 2.5%, which is higher than the S&P 500's 1.8% dividend yield but far lower than the 4.5% three-month Treasury Bill rate. When oil and gas stocks were under stress and ExxonMobil and Chevron yielded above 6%, compared to under 2% for the three-month Treasury Bill, then the dividend argument was much stronger. But because the rise in stock prices (and subsequent decline in dividend yield) of many of these value stocks coincided with the rise in the risk-free rate, the dividend argument simply isn't as strong as it used to be.

What really seals the deal for growth over value is taking a step back and thinking about the companies that are going to shape the economy for the next 10 or 20 years. With large-cap growth stocks, like those that lead the Vanguard Growth ETF, an investor is getting exposure to a medley of exciting industries, including cloud IT infrastructure, consumer electronics, streaming, semiconductors, e-commerce, electric vehicles, self-driving cars, robotics, automation, quantum computing, next-generation financial tools, and more.

For folks that are net savers and don't need their investment funds for over a decade, it makes much more sense to bet on these trends than it does to focus too much on dividends.

Finding a balance that works for you

For most people, going all-in on growth stocks or value stocks is a bad choice, no matter how compelling the investment theses. Rather, a mix between the two types of stocks is more effective. The distribution of that mix will likely depend on your personal risk tolerance, time horizon, and investment objectives.

Most young investors with long-term time horizons naturally gravitate toward growth stocks. But even if you have a 30, 40, or even 50-year time horizon before retirement, your personal risk tolerance and aversion to market volatility may make it better to include a large percentage of value stocks in your portfolio.

Knowing yourself is just as important as making wise investment decisions. Because picking the best stocks is pointless if you sell it too early or in a panic during a bear market.

But for investors that are interested in growth stocks and can stomach their higher volatility, last year's steep sell-off, paired with the discounted valuations of many top growth stocks, makes now one of the best times in years to invest in quality growth stocks.