Growth stocks give investors the chance to invest in exciting, fast-moving companies with the potential to produce monumental share price gains, but they often carry high price tags. Value stocks, on the other hand, give investors an opportunity to invest in companies that have fallen out of favor and whose stock price has dropped to bargain levels below their actual value.
Wall Street likes to categorize stocks neatly as either growth or value stocks. The truth is a bit more complicated, as some stocks have elements of both value and growth. Nevertheless, there are important differences between growth and value stocks, and many investors prefer one style of investing over the other.
Growth stocks prioritize going from small, up-and-coming businesses to leaders in their respective industries as quickly as possible. Early on, growth stocks tend to concentrate on building up their revenue, often at the cost of delaying profitability until a future date. After a period of time, growth stocks start focusing more on maximizing profits. As those key financial metrics grow, the perceived value of the company rises in the eyes of growth-minded investors. That can create a positive feedback loop, as a rising stock price can boost a growth stock's reputation, helping it win even more business opportunities.
Read More: Investing in Growth Stocks
Value stocks feature attractive valuations that offer investors a bargain compared to the actual value of the company. They typically have below-average price-to-earnings or price-to-book ratios, making them inexpensive to many investors.
Value stocks don't have flashy growth characteristics, but they often have steady, predictable business models that generate modest gains in revenue and earnings over time. Some value stocks are in businesses that are in decline, but their stock price is so low that it understates the value of the profits they'll be able to generate in the future.
Read More: Investing in Value Stocks
Which is better: growth or value?
Both growth stocks and value stocks offer lucrative investing opportunities to their shareholders. The best investment style for you depends largely on your personal financial goals and your investing preferences.
Growth stocks are more likely to be appealing if the following things apply to you:
- You're not interested in current income from your portfolio. Most growth stocks avoid paying significant dividends to their shareholders. That's because they prefer to use all available cash by reinvesting it directly into their business to generate faster growth.
- You're comfortable with big stock price moves. The price of a growth stock tends to be extremely sensitive to changes in future prospects for a company's business. When things go better than expected, growth stocks can soar in price. When they disappoint, however, higher-priced growth stocks can fall back to Earth just as quickly.
- You're confident that you can pick out winners in emerging industries. You'll often find growth stocks in fast-moving areas of the economy, such as technology. It's common for many different growth companies to compete against each other. To maximize your returns from growth investing, you'll need to pick as many of the eventual winners in a given industry as you can while avoiding the downward impact of investing in the losers.
- You have plenty of time before you'll need your money back. Growth stocks can take a long time to realize their full potential, and they often suffer setbacks along the way. In order to make the most of a growth stock, it's critical that you have a long enough time horizon to give the company a chance to grow into a leadership role in its industry.
Value stocks will look more attractive to investors who seek these characteristics:
- You want current income from your portfolio. Many value stocks pay out substantial amounts of cash as dividends to their shareholders. Because those businesses lack significant growth opportunities, they have to make their stock attractive in other ways, and paying out attractive dividend yields from their ample cash flows is one way to get income investors to look more closely at a stock.
- You prefer more stable stock prices. Value stocks don't tend to see very large movements in either direction. As long as their business conditions remain within predictable ranges, stock price volatility is usually low with value stocks.
- You're confident that you can avoid value traps. In many cases, stocks that look cheap are cheap for good reasons. Companies that have lost their competitive edge or that can't keep up with the pace of innovation in an industry can easily see their share prices keep falling indefinitely. Investors have to be able to look past attractive valuations to see when a company's future business prospects are poor.
- You want a more immediate payoff from your investment. Value stocks don't turn things around overnight, but you can often tell when a company is taking steps to address the issues that caused its stock to become attractively priced. If a company is successful in getting its business moving in the right direction, then its stock price can rise quickly once investors see that its overall strategy is working. The best value investors identify and buy shares of those stocks before other investors catch on.
Finally, when it comes to overall long-term performance, there's no clear-cut winner between growth and value stocks. When economic conditions are good and stocks are in bull markets, growth stocks on average modestly outperform value stocks. However, during more difficult economic times, value stocks tend to hold up better than their growth stock counterparts. Therefore, which group outperforms depends a lot on the specific time period that you're considering.
Tracking growth and value indexes
These trends can be seen in growth and value indexes, which are benchmarks designed to track each group of stocks. For instance, the S&P 500 Growth Index (NYSEMKT:SPYG) draws from the roughly 500 stocks in the S&P 500, choosing those stocks that have the best three-year growth in revenue and earnings per share with the strongest upward momentum in their stock price. The S&P 500 Value Index (NYSEMKT:SPYV) selects stocks with the most attractive valuations based on several major stock valuation metrics.
There's no reason you can't own both growth stocks and value stocks. Each group has its own attractive qualities, and having diversified exposure to both in your portfolio can give you the best of both worlds. However, it's also fine if you identify more with one investing style than the other. Depending on what you're trying to accomplish with your investments, you might find that concentrating on either growth stocks or value stocks makes you more comfortable with your overall financial strategy. That's the key to being a successful investor.