Growth stocks have outperformed value stocks in recent years, and the gap between the two’s performance significantly widened amid Covid-19. However, some analysts believe that value stocks will soon make a comeback.
In this article, we explain what growth and value stocks and discuss their performance and different outlooks.
What are growth stocks?
Growth stocks are stocks that are expected to grow at a rate above the average market rate. Aside from this, growth stocks typically have several other common characteristics:
- High price/earnings (P/E) ratio: The P/E ratio measures a company’s stock price relative to its earnings per share (EPS). Growth stocks can have a high P/E ratio, meaning they trade at high prices while having little or no revenue, but, in this case, earnings are expected to grow in the future.
- No dividends: Growth stocks typically do not pay dividends as earnings are reinvested into the company to accelerate growth.
- Higher volatility: Growth stocks can be more volatile than the broader market.
- Riskier: There is potential for high returns, however, business models may be unproven, and there can be a high level of uncertainty surrounding growth companies. As they typically have higher-than-average prices, they can also experience large price drops if expectations aren’t met.
Growth companies tend to have a competitive advantage over other companies in the same industry, such as patents or technology, unique product lines and loyal consumer bases. As a result, they may have considerable market share in their respective industries. Examples are Tesla, Netflix and Amazon.
What are value stocks?
In contrast to growth stocks, value stocks are classified as stocks trading at a price lower than their intrinsic value. In other words, these are stocks that are undervalued compared to what the company’s financials, such as revenue or earnings, may indicate. Some other attributes of value stocks are:
- High dividend yield: Value stocks typically have a history of paying substantial cash dividends to shareholders.
- Low P/E ratio: Given that value stocks are undervalued, they typically have a low P/E ratio.
- Low price-to-book (P/B) ratio: The P/B ratio compares a company’s stock price with its book value, the difference between its liabilities and assets. Value stocks have a low P/B ratio, usually below 1.
- Less risky: Since value stocks tend to be established companies with proven business models withstanding the test of time, they can be less risky and volatile compared to growth stocks.
Investing legend Warren Buffett is one of the most well-known proponents of a value investing strategy. Since value stocks are perceived to be cheap or discounted compared to their true worth, value investors like Buffett anticipate that the stock’s price will rise to reflect its intrinsic value in the long term. However, it is, of course, never guaranteed that prices will appreciate.
Value stocks are typically mature companies with modest gains in earnings over time. Examples are Bank of America, Johnson & Johnson and Intel.
Growth or value?
Choosing a growth or value investment strategy both offer benefits and drawbacks. It is important to make investment decisions based on your investment plan, considering factors such as risk tolerance and investment horizon. Including a mix of growth and value stocks in your portfolio can help with diversification and spreading the risk.
In terms of performance, of course, this varies from company to company and depends on many factors. To compare value and growth stocks in a broader spectrum, below is the performance of the S&P 500 Value and S&P 500 Growth indices from Q1 2019-Q1 2021:
As you can see, the gap between the performance of US growth and value stocks significantly widened starting at the end of Q1 2020. As stated by the Financial Times, value stocks had their worst year ever in 2020 relative to growth stocks. However, it is important to keep in mind that past performance is not a guarantee of future results.
Analysts at leading institutions have mixed outlooks on whether growth stocks will continue to outperform value stocks. Analysts at Blackrock, for example, believe that while the Covid-19 pandemic has helped propel many growth companies, some trends in favour of growth stocks were already in play before the pandemic and are here to stay. According to Blackrock, shopping malls, for example, were already in danger before the spread of Covid-19, and it has accelerated the trend of shopping online in a stay-at-home world.
On the other hand, for example, is T. Rowe Price. According to their analysts, value stocks rallied after the announcement of the first vaccine trial results. They say that since spending habits have been muted, allowing consumers to save, there could be a release of pent-up demand bolstering companies that were hit hard from the pandemic as soon as the vaccine distribution is widespread and life is more normalised.
The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Please be aware that facts may have changed since the article was originally written.
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Sources: Financial Times, Investopedia, Motley Fool, Harvard Business Review, S&P Global, Corporate Finance Institute, Blackrock, T. Rowe Price
