Value vs. Growth Stocks: What Strategy Is Best for Me?
Published Sat, May 16 2020 1:50 PM PST
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By Obioha Okereke
There are countless investment strategies today for investors to choose from. Value investing and growth investing are two of the most common buckets people fall into…do one of these strategies make sense for you?
In Passive vs Active Investing, we talked about the process for picking what kind of investor you’d like to become. As you continue to decide what to invest in, and where to start, we wanted to explain some of the different types of stocks.
There are two primary categories for stocks that you should be aware of:
Growth
Value
Today, we’re going to talk about how these two stock types roll out into two different investment strategies.
Value Investing
The premise of value investing is to find undervalued stocks that are trading below their true value. Value investors, like Warren Buffett, look to purchase stocks that have great long-term potential.
How do I know if a company is current undervalued? Good question.
One way to identify a value stock is to compare the stock price of a company, to that of its competitors. For instance, if Alaska Airlines and Southwest Airlines are trading at $50 and $60 a share respectively, and JetBlue is trading at $18, some might say JetBlue is undervalued. If JetBlue has solid revenue and fundamentals, a smart value investor would scoop up shares and wait until the value was widely recognized in the market.
JetBlue would be undervalued because despite having solid performance, its price is far less than that of its competitors.
Value stocks are known to pay high-yield dividends!
Finding Value Stocks
“A value stock is typically more likely to have a higher long-term return than a growth stock because of the underlying risk”
The coronavirus had very widespread impacts in the stock market and created some great opportunities for both value, and growth investors.
Let’s take a look at an example!
On February 19, QQQ, a popular ETF, was trading at about $237 a share. By March 20, the stock was down to $170 a share. This created a value opportunity because a stock that normally trades at a higher price, sunk lower due to a surprise event.
QQQ is an ETF that tracks the largest stocks in the NASDAQ. Among its holdings are:
· Apple
· Microsoft
· Amazon
· Alphabet
The sharp decline of QQQ’s stock price presented a unique opportunity to purchase shares at a bargain which was a dream situation for value investors. If you bought shares of QQQ on March 24 at a price of $179, today you would be up over 20% on your investment as QQQ is currently trading at about $222 a share.
This means that in less than two months, the stock increased roughly 24%!
Full disclosure: I bought several shares of QQQ in late March when it decreased. I purchased under the premonition that when the economy got back to normal, the price of QQQ would reflect its previous highs. I’ve followed QQQ for 5 years (since I started investing), so I knew it was undervalued when compared to its previous highs. I was also fairly confident the prices of the companies in its portfolio were bound to increase in due time. If you remember, QQQ has holdings in some of the world’s largest tech companies.
This is just one of many instances in recent months where investors had the opportunity to purchase shares of stocks at bargain prices.
Important Metrics of Value Stocks
The key to value investing is to focus on a company’s fundamentals and long-term potential, not just its current stock price and present market conditions. One of the largest mistakes people can make is panic selling. This is where due to rapid declines in the stock market, people sell off their positions in companies. Instead, consider spending money to buy up shares of companies that were previously expensive, but are now trading at lower prices.
Read: Why Long-Term Investors Should Never Sell Stocks in a Panic
Value stocks typically have the following characteristics
Low price to earnings ratio (P/E ratio)
Price to book ratio of 1 or less
Debt to asset ratio of 1.10 or less
High Dividend Yield
Price to earnings ratio - This is a calculation of the dollar amount an investor would need to invest in a company, in order to receive a dollar of that company’s earnings. A high P/E ratio can be an indication that a company is over-valued.
Price to book ratio - A measurement that is found by dividing a company’s stock price by its book value per share.
Debt to asset ratio - This shows you the percentage of a company’s assets that were financed by creditors. In other words, it shows the ratio of a company’s assets, to its liabilities.
High Dividend Yield - Probably the easiest to understand of the metrics I’ve mentioned. Dividend yield is simply the amount of a dividend, relative to stock price. For instance, if a dividend is $1 and the stock price is $40, the dividend yield is 2.5%. A high dividend yield is determined by comparing a dividend yield of a company, to that of a benchmark.
If you’d like to learn more about dividends, check out Common Stock, Preferred Stock, and Dividends.
These are all statistics that you can find in a Google search of any company you’re interested in. We won’t spend too much time talking about ratios, and dividend yield today as I want to focus on the basics.
Be honest, did any of these metrics even make any sense? Don’t worry, you won’t need to spend time calculating them as most finance sites will list them for you.
Growth Investing
The whole point of investing is to have your money work for you right? The main focus for growth investors is to grow their money by beating market returns. Inherently, they are willing to take on more risk to achieve larger returns, and generally their portfolios are comprised mostly of equities. This is as opposed to having large bond, and cash positions. Growth companies are often newer companies that have quickly accelerating revenue and are likely to expand.
It is easy to get value and growth stocks mixed up.
When deciding where to focus, be aware that growth stocks carry a higher level of risk than value stocks – as the saying goes, greater risk equals greater reward.
What Strategy is best for me?
According to Mark Cussen from Investopedia, the question of whether a growth, or value investing strategy is better depends on your investing time horizon and the amount of risk you can tolerate.
Value stocks tend to be large, well-established companies that pay dividends. Think of Coca-Cola, Bank of America, and Microsoft (my favorite stock).
Growth stocks will be companies like Twilio, and Tesla that are growing rapidly and increasing in size. Because the prices of these stocks are more volatile and have the potential to greatly outperform the market, they’re suitable investments for individuals who can tolerate risk, and are looking to obtain above-average returns.
To help you understand the difference in performance of value and growth stocks, I’ll show the five-year performance of some of the stocks in my portfolio. I’ve organized them by value, and growth.
The following numbers are brought to you from the Robinhood app I have on my phone. Percentages are as of May 11, 2020.
Value
Microsoft (+292.43%)
Coca-Cola (+11.18%)
Starbucks (+52.48%)
Growth
Docusign (+217.37%)
Revolution Medicines (+34.35%)
Twilio (+679.49%).
Yes, you read that right.
Twilio has a 5-year return of almost 700%. I was fortunate to buy a couple shares at $78 a few weeks ago. Today, it is trading at $182! Unfortunately, I only bought 4 shares to test the waters and as a result, I’ve only made about $400 when I could have easily made much more. As mentioned before, more risk, more reward!
Before you get excited, I need you to realize that these in no way reflect average returns. In the long term, value stocks have an average return of 17%, for growth stocks, that number drops to 12.6%.
What Goes Up…
Above, I shared the performance of companies that are doing well. It is crucial for you to remember that not all stocks go up, and in some cases, you can lose money. Since I started investing, I’ve lost close to $10,000 in the stock market. Keeping things honest, most of that has come from trading and speculative investments, not long-term investments.
We’ll chat about all of that another time…
One of the most important things I’ve learned about investing is to leave emotions out of it. Don’t get greedy, avoid buying into companies because you fear missing out, and for the traders out there, don’t get married to a stock.
Stick to a strategy and like all things, in the long-term, it will pay off.
I Still Don’t Understand the Difference
Remember these two key takeaways:
Growth stocks are stocks that have the potential to, or, are expected to outperform the market because of their future potential (something that’s a game changer i.e. Tesla)
Value stocks are stocks that are undervalued and offer investors the unique opportunity to invest in a company that is not correctly priced. When done correctly, value investing can produce above-average returns
My personal opinion…don’t pick one. Just do both.
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