Growth stocks are those companies that are considered to have the potential to outperform the overall market over time because of their future potential. Value stocks are classified as companies that are currently trading below what they are really worth and will thus provide a superior return. Which category is better? The comparative historical performance of these two sub-sectors yields some surprising results.
- Growth stocks are expected to outperform the overall market over time because of their future potential.
- Value stocks are thought to trade below what they are really worth.
- The question of whether a growth or value stock strategy is better must be evaluated in the context of the investor's time horizon and risk.
What is Value Investing?
Growth Stocks vs. Value Stocks
The concept of a growth stock versus one that is considered to be undervalued generally comes from the fundamental stock analysis.
Growth stocks are considered by analysts to have the potential to outperform either the overall markets or else a specific subsegment of them for a period of time.
Growth stocks can be found in small-, mid-, and large-cap sectors and can only retain this status until analysts feel that they have achieved their potential. Growth companies are considered to have a good chance for considerable expansion over the next few years, either because they have a product or line of products that are expected to sell well or because they appear to be run better than many of their competitors and are thus predicted to gain an edge on them in their market.
Value stocks are usually larger, more well-established companies that are trading below the price that analysts feel the stock is worth, depending upon the financial ratio or benchmark that it is being compared to. For example, the book value of a company’s stock may be $25 a share, based on the number of shares outstanding divided by the company’s capitalization. Therefore, if it is trading for $20 a share at the moment, then many analysts would consider this to be a good value play.
Stocks can become undervalued for many reasons. In some cases, public perception will push the price down, such as if a major figure in the company is caught in a personal scandal or the company is caught doing something unethical. But if the company’s financials are still relatively solid, then value-seekers may see this as an ideal entry point, because they figure that the public will soon forget about whatever happened and the price will rise to where it should be.
Value stocks will typically trade at a discount to either the price to earnings, book value, or cash flow ratios. Of course, neither outlook is always correct, and some stocks can be classified as a blend of these two categories, where they are considered to be undervalued but also have some potential above and beyond this. Morningstar Inc., therefore, classifies all of the equities and equity funds that it ranks into either a growth, value, or blended category.
Growth vs. Value: Performance
When it comes to comparing the historical performances of the two respective sub-sectors of stocks, any results that can be seen must be evaluated in terms of time horizon and the amount of volatility, and thus risk that was endured in order to achieve them.
Value stocks are at least theoretically considered to have a lower level of risk and volatility associated with them because they are usually found among larger, more established companies. And even if they don’t return to the target price that analysts or the investor predict, they may still offer some capital growth, and these stocks also often pay dividends as well.
Growth stocks, meanwhile, will usually refrain from paying out dividends and will instead reinvest retained earnings back into the company to expand. Growth stocks' probability of loss for investors can also be greater, particularly if the company is unable to keep up with growth expectations.
For example, a company with a highly touted new product may indeed see its stock price plummet if the product is a dud or if it has some design flaws that keep it from working properly. Growth stocks, in general, possess the highest potential reward, as well as risk, for investors.
Although the above paragraph suggests that growth stocks would post the best numbers over longer periods, the opposite has actually been true. Many studies point to value having outperformed growth style over long-term periods. However, looking at more recent data, value did outperform for the first 10 years of the 2000s, but growth has outperformed over the last 10 years. Take note that dividends likely play a key role in helping value outperform over longer-periods.
Going back to 1926, value has had numerous periods of outperformance relative to growth. Again, despite the long-term outperformance, growth has reigned supreme over the last decade. With that, the S&P 500 is made up of roughly 40% technology stocks.
What Percent of the S&P 500 Is Growth vs. Value?
The S&P 500 is not broken down into growth and value stocks. However, the two sectors that are often considered growth are technology and consumer discretionary, which make up 40% of the index. Meanwhile, value sectors—financials, industrials, energy, and consumer staples—make up roughly 29% of the index.
What Is an Example of a Value Stock vs. Growth Stock?
An example of a value stock would be a bank, such as JPMorgan Chase (JPM). While key growth is often found in the technology space, such as Google (GOOG).
Are Growth or Value Funds Better for the Long-Term?
Value has outperformed growth stocks over the longer-term, however, growth has been outperforming for the last 10 years.
The Bottom Line
The decision to invest in growth vs. value stocks is ultimately left to an individual investor’s preference, as well as their personal risk tolerance, investment goals, and time horizon. It should be noted that over shorter periods, the performance of either growth or value will also depend in large part upon the point in the cycle that the market happens to be in.
For example, value stocks tend to outperform during bear markets and economic recessions, while growth stocks tend to excel during bull markets or periods of economic expansion. This factor should, therefore, be taken into account by shorter-term investors or those seeking to time the markets.