When it comes to investing, people often differentiate between two main schools of fundamental investing approaches. These approaches are defined as growth investing and value investing. Growth investing primarily aims to find companies that are likely to grow extraordinarily, without considering the price. Value investors, on the other hand, try to buy good quality businesses for a substantial bargain of their value. While it is difficult to tell which strategy is better, understanding the characteristics of both is relatively easy and also necessary in order to assess the question of what really makes the boundaries between those investing styles.
Characteristics of Growth and Value
Most investors set clear differences between growth investing and value investing since both investing styles take different approaches and criteria for picking stocks. Both growth and value stocks come with typical characteristics that differ from each other.
The focus of growth investing solely lies on stocks that show high potential on exceptionally increasing profitability and growing capital of the business. Therefore, growth stocks are mostly expected to perform extraordinarily and grow at a faster pace than most other stocks. The high expectation for future growth from investors leads to typical characteristics of growth stocks such as
Higher Volatility. The price of growth stocks can heavily fluctuate as a result of short term incidents within the business and industry, or in accordance with earning results. Investors tend to especially have an eye on the projected earnings of growth stocks and when expectations fall short, stock prices will usually suffer to a greater extent than other stocks.
High Price Multiples. Because of their immense growth in the future, investors are willing to pay higher prices for growth stocks than what they currently offer. This is why growth stocks usually have higher price multiples such as an increased P/E ratio than the broader market.
Increased Risk. While growth companies primarily attract investors because of their good potential of generating great profits to the investors, it may be difficult to please long-term minded shareholders since most growth stocks don’t pay any dividends. This concludes that growth stocks are especially affected by short term uncertainty, as any negative news for the business will have a bigger impact on expectations and therefore market prices.
In order to focus on expanding, growth companies usually pay very little or zero dividends. This ensures that all the available capital is reinvested into the business for increased efficiency. Many stocks are considered growth stocks because they not only show strong signs of growth in the past but are also expected to increase earnings and revenue at a faster rate than other companies in the future.
A common trait of growth companies is that they usually have some sort of competitive advantage that acts as a catalyst for the immense growth of the business at some point in the future.
A value stock is usually defined as a stock that is trading at a lower price relative to fundamental metrics such as earnings, sales, dividends and more. Many investors are looking for value stocks with the assumption that undervalued companies will eventually rebound back to their true price and grow further since the current price doesn’t represent their real fundamental value.
Not every stock that is considered undervalued necessarily makes a good value stock. Experienced value investors don’t exclusively seek for cheap stocks but rather great companies that are additionally trading at a bargain to their value. Those bargains usually come when the market views them as unfavorable in bad times such as stock market crashes, bear markets, or economic downturns.
Common characteristics of value stocks are
Solid balance sheets. The balance sheet is one of the three primary financial statements and indicates the current financial health of a company. Value stocks usually have stable financial health that is backed up by strong numbers within the balance sheet including low debt, large amounts of cash, and a solid amount of equity that greatly exceeds company’s debt.
Low price multiples. Typical characteristics of value stocks are low price multiples that are indicating the undervaluation of the company. Well-known fundamental metrics for value are a low price-to-earnings ratio, low price-to-book ratio, and high dividend yield.
Consistent and stable growth. Great value stocks don’t only hold solid balance sheets and healthy amounts of cash flow but also provide a history of consistently growing financial prospects. As opposed to growth stocks that might go through time periods of inconsistent but substantial growth, great value companies should grow at a consistent rate as possible. This makes their future prospects generally more predictable than growth stocks, which is crucial to accurately estimate and assess a stock’s value.
Value stocks don’t necessarily need to represent major companies. Favorable companies that are trading at a bargain of their value can be possibly found in every industry and market sector ranging from small-cap businesses to multi-billion dollar companies. Arguably the most important part is the price at which the stock can be bought. Investing in stocks that are trading at a discount of their value is what differentiates value investing from most other investing styles. In order for value investors to know at which price point to invest, the true value of the stock has to be assessed in the first place.
Determining the true value of a stock is an important part of the analysis for most value investors. That true value is also defined as the intrinsic value and was primarily introduced by Benjamin Graham, who is also considered as the father of value investing.
There are several approaches to assessing the intrinsic value of a business. One common way is the discounted cash flow model, also used by Warren Buffett, one of the most famous and successful investors of all time. The DCF model essentially aims to define the intrinsic value as the sum of all the future cash flows that a company can provide for the investor, discounted back into the present.
Growth Investing vs Value Investing
If we generalize both investing styles by their typical characteristics, we can see that value investing has beaten growth investing in most periods of time throughout history, while growth investing heavily outperformed value in the past 10 years:
“Growth” tends to do well in long and sustainable bull markets, rising corporate earnings, low-interest rates, and great economic expansion.
“Value” on the other side performs well when companies recover from economic downturns and market turmoils. Cyclical stocks are often part of most value stocks, as they are especially dependent on economic circumstances
The question of which investing style turns out the better can’t really be answered since each strategy tends to perform better depending on the time period, market situation and economic circumstances at which stocks of each kind are held.
Many investors and even professionals on Wall Street try to clearly separate growth and value investing from each other. While there are definitely several characteristics that are typical to each investing style, it should be noted that each approach often overlaps with each other.
The primary growth aspect of growth investing does, in fact, play a critical role in the valuation process of many value investors since growth estimation is required in order to assume the future cash flow of a company to further arrive at a certain intrinsic value. Therefore, value investors might as well buy what other investors would define as a “growth stock” as long as it fits their personal criteria, including the price at which the stock can be bought.
Constantly comparing both investing schools and their performance with each other doesn’t give a great amount of insights since each experienced investor will likely have their own investing approach with criteria coming from both investing styles.