Growth stocks are considered stocks that have the potential to outperform the overall market over time because of their future potential, while value stocks are classified as stocks that are currently trading below what they are really worth and will therefore 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 may trade below what they are really worth and will therefore theoretically provide a superior return.
- The question of whether a growth or value stock investing strategy is better must evaluated in the context of an individual investor's time horizon and the amount of volatility, and thus risk, that can be endured.
Growth Stocks vs. Value Stocks
The concept of a growth stock versus one that is considered to be undervalued generally comes from 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 achieve 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 is 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 they 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. (See also: Value Investing: Introduction.)
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.
Which is Better?
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 predicts, they may still offer some capital growth, and these stocks also often pay dividends as well. (Learn more about: The Value Investor's Handbook.)
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, 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. Research analyst John Dowdee published a report on the Seeking Alpha website where he broke stocks down into six categories that reflected both the risk and returns for growth and value stocks in the small-, mid- and large-cap sectors, respectively. The study reveals that from July 2000 until 2013, when the study was conducted, value stocks outperformed growth stocks on a risk-adjusted basis for all three levels of capitalization—even though they were clearly more volatile than their growth counterparts. However, this was not the case for shorter periods of time. From 2007 to 2013, growth stocks posted higher returns in each cap class. The author was forced to ultimately conclude that the study provided no real answer to whether one type of stock was truly superior to the other on a risk-adjusted basis. He stated that the winner in each scenario came down to the time period during which they were held. (Learn more about: Steady Growth Stocks Win the Race.)
However, Craig Israelsen published a different study in Financial Planning magazine in 2015 that showed the performance of growth and value stocks in all three cap sizes over a 25-year period from the beginning of 1990 to the end of 2014. The returns on this chart show that large-cap value stocks provided an average annual return that exceeded that of large-cap growth stocks by about three quarters of a percent. The difference was even larger for mid- and small-cap stocks, based on the performance of their respective benchmark indices, with the value sectors again coming out the winners. But the study also showed that over every rolling five-year period during that time, large-cap growth and value were almost evenly split in terms of superior returns. Small-cap value beat its growth counterpart about three quarters of the time over those periods, but when growth prevailed, the difference between the two was often much larger than when value won. However, small-cap value beat growth almost 90% of the time over rolling 10-year periods, and mid-cap value also beat its growth counterpart.
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.