Understanding growth versus value investing

Two frequently used terms when purchasing stocks are growth and value. In a sense you would want to own stocks that possess both characteristics, in that they would have strong growth potential, but are also reasonably priced. Oftentimes though, some investors tend to favor either a growth style or a value style.

Growth stocks are companies that typically can grow earnings faster than the overall market. In purchasing stocks that are growing faster you would normally expect to pay a premium. That is growth stocks typically would have a higher price relative to current earnings, or underlying assets versus the overall market.

Value stocks tend to be found in slower growth industries.  These companies, for a given level of earnings, will normally be priced lower versus growth stocks.  In addition value stocks normally have a greater dividend yield versus growth companies.

Looking at income producing real estate might offer a good comparison.  A person may purchase a building with rents yielding 7 percent in a slow growing market, but in the faster growing market rents might only yield 5 percent.  The growth investor would be willing to purchase the lower yielding property, while the value investor would want the higher current yield.

In a perfectly efficient market it shouldn’t make much difference in terms of total return whether someone is a growth or value investor.  The value investor would have less price appreciation, but would make up for it with a greater dividend yield.  For the growth investor, it would be just be the opposite.

Looking at historical returns value investors have tended to do a little better than growth investors. This is largely due to the fact that expectations for growth stocks sometimes do not materialize. Nonetheless, there are many time periods when growth stocks perform better than value stocks.

What often determines whether growth or value is performing better, is how respective industries are doing.  For example value stocks tend to be found among the financial and utility industries, while growth stocks predominate in healthcare and technology.

In theory someone would expect value stocks to offer more downside protection in a market downturn.  However, many value stocks have cyclical characteristics, so in a weak economy they often perform poorly.  During the severe market correction in 2008 financial stocks, which are predominately value stocks, were the worst performers.

During the other recent major market correction from 2002 to 2002 it was technology stocks that bore the brunt of market losses, so it was growth investors who were impacted the most.   Therefore, it is important for an investor to be aware that certain investment styles can have heavy representation in various industries.

I think that for most investors a market-based fund, such as an S&P 500 index, makes the most sense.  This type of fund would essentially be represented by both growth and value.  Someone who invests primarily in either a growth or a value fund can oftentimes have returns in a given year that deviate significantly from the overall market.

For someone who is a more sophisticated investor, there are certainly times when emphasizing a growth or a value style makes sense. There have been times when growth or value has been priced more attractively versus the other style.  At the present time, I don’t believe that one style is priced significantly better versus the other.

I believe that for most investors, after having a broad based market fund, having some representation in a foreign fund and small or mid-cap fund is appropriate. Beyond that, having a specialized growth or value fund is probably not necessary, unless market circumstances change significantly.