Growth investing and value investing are two distinct approaches to asset allocation. There has always been a lively debate about which one to choose, as both have their own characteristics and depend primarily on one's objectives, risk appetite, and current financial environment.
The underperformance of value stocks relative to growth stocks has been one of the most prominent patterns over the last decade. However, given the present climate, this might be about to change.
Growth investing focuses on firms that strive to quickly transition from start-up status to large-capitalization. These ventures are prone to prioritizing revenue growth over profitability in the early stages. This snowball effect increases the stock price, visibility, and market sentiment. As such, growth stocks have relatively high valuations as measured by their ratios. They tend to outperform their peers in terms of revenue and earnings growth.
Therefore, above-average revenue growth is a critical indicator when seeking growth stocks. These, in general, do not exhibit a long history of high profitability but rather the potential for exponential growth. Nowadays, growth stocks are mainly found in the technology sector.
Growth stocks tend to attract more risky and speculative investors. In addition, growth investing implies foregoing quick earnings, as the underlying companies typically reinvest dividends in their operations rather than distributing them to investors, allowing them to capitalize on growth. Furthermore, growth stocks are notoriously volatile in relation to market sentiment. As a result, they expose their investors to a high level of risk and a higher potential gain.
On the other hand, value stocks relate to publicly traded companies that sell at a discount to their profitability and long-term growth prospects. They compensate for their lack of high growth potential with solid, predictable business structures that generate consistent revenue over the long run.
Investors use a comparative examination of the market valuation and the underlying value of a company to find value stocks. Financial documents, business models, and the company's overall position compared to the competitors can all be used to calculate the underlying value. A value stock is one in which the company's current value is less than its underlying value. Financials, healthcare, industrials, or energy are examples of growth sectors.
Value investors are interested in companies whose current stock price, in their judgment, undervalues their future profits potential, which they forecast to increase tenfold. Their profile is more risk and protection-oriented. Since value companies often pay dividends, they reduce their growth potential for stability. In turn, these stocks generally offer low levels of volatility.
A Potential Shift
The debate over the performance differences between growth and value stocks has long been a matter of discussion among investors, with growth stocks known to outperform in the short term but lag behind value stocks in the long run. However, the 2008 crisis marked a clear break between the two, with growth stocks displaying increased performance in recent years.
This development may prompt investors to seek out growth stocks, as they have outperformed value stocks over the past decade. However, they should keep in mind that pursuing performance may lead to unsatisfactory results. Furthermore, in light of recent events in early 2022, some predict that the outperformance of growth stocks may be coming to an end. Using ETFs as examples, the VOOV Value Index is down 4.65% YTD, while the VUG Growth Index plunged 19.29% YTD (as of March 15, 2022).
Indeed, significant depressions such as the internet bubble of 2000, the 2008 financial crisis, and the recent Covid-19 outbreak have seen value stocks rebound versus growth companies, which are much more sensitive to market downturns.
The current macroeconomic environment, which is characterized by high inflationary pressures, may contribute to the resurgence of value investing: In times of inflation, value companies can enhance their profit margins by raising prices. As a result, they have tangible operating outcomes to base and improve. This is not the case for growth companies, as they rely primarily on predicted earnings. And since investors tend to look for portfolio hedges in volatile financial environments, they prefer to allocate more tangible, quantifiable assets, which push value stocks higher.
Similarly, enthusiasm in technology stocks, IPOs, SPACs, and other growth values has been waning. Consequently, the correlation between U.S. market value and growth equities has highly decreased recently.
All those elements led investors to sell their growth equities, fearing that increasing interest rates would put downward pressure on their stock valuations. On the other hand, they have allocated to value equities to prepare their portfolios for a period of rising inflation.
It is important to note that growth and value stocks are far from being mutually incompatible. Together, they provide portfolio diversification benefits to investors.
The Bottom Line
The old debate between growth and value investing is still alive and well. Although growth stocks have stolen the show over the past decade, the trend is currently turning around.
Finally, any outcomes that can be observed should be evaluated in terms of time horizon and level of volatility and risk experienced.
Because value stocks are typically found among larger, more established firms, they are thought to have a lower level of risk and volatility. Despite their lower predicted returns, they have proved their ability to generate capital growth over time and a high level of liquidity owing to dividend payments.
On the other hand, growth companies reinvest earnings back into the company to fuel its development. They meet other investors' demands and return objectives while posing higher degrees of risk.
In summary, because markets are always navigating through many external factors, trends, and surroundings, investors must maintain an adaptative portfolio.
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