Difference Between Growth Stocks and Value Stocks
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There is a reason some people make a whole career out of giving professional investing advice. There is a lot – a LOT – to learn.
Take stocks, for instance. At first, it seems like they are just stocks. But then you dig deeper.
Suddenly you realize there are two major categories of stocks. And five major types of stocks. And then you run across an article (like this one, for example) that discusses growth vs value stocks.
It becomes instantly clearer how you could spend a whole investing lifetime just studying stocks and you might still never know everything there is to know about actually trading stocks.
And you don’t have a lifetime. You have about 10 minutes. Which is where we come in.
In this article, we give you a quick and dirty overview of “the stock” as an asset class. Then we dive into growth vs value stocks so you understand the difference and how each one might fit into your greater investment strategy.
What Is a Stock?
At its simplest, a stock is a share of ownership. What do you own? You own one share’s worth of the issuing entity’s profitability.
The two major categories of stocks are preferred stocks and common stocks. The former are in the minority and come with fixed dividend payments at regular intervals but no voting rights. They are less risky as far as stocks go but still risky in comparison with many other asset classes.
The five major types of stocks are big cap stocks, small cap stocks, micro-cap stocks, nano-cap stocks and penny stocks. The first two types are viewed as less risky than the second two types. Penny stocks are – in a word – risky.
But what are growth stocks? What are value stocks, for that matter? Which is better, growth vs value stocks? Let’s find out!
What Is a Growth Stock
A growth stock is named for its growth potential. In a nutshell, growth stocks are expected to grow (appreciate) faster than what the market average forecasts for stocks in general.
You might be wondering how a stock’s growth is forecasted, which is an excellent question.
Analysts use different metrics (measurements) to anticipate how a stock will perform over time. These metrics can include stock sales and company sales. They can also include (but are not limited to) high price-earnings ratios, book value and cash flow.
One key component for many growth stocks is lower than average dividend payouts. Why is this important? Because a company that pays out less in dividends has more to reinvest into profitability.
Another important fact to know about growth stocks is that they are found in nearly all sectors of the stock market.
Big cap stocks (companies with $10 billion or more in assets) certainly occupy a healthy share of growth stocks. But small cap stocks (companies with less than $10 billion in assets) and even certain micro-cap stocks (companies with $50 to $300 million in assets) may be classified as growth stocks.
Growth stocks can be controversial.
One the one hand there is an argument to be made that growth stocks, once identified, experience value inflation. After all, who doesn’t want to add a stock that is forecasted to be a “sure thing” to their investment portfolio?
On the other hand, it is also important to remember that in many cases, adding growth stocks to your portfolio means sacrificing dividends – in part or perhaps entirely – in service to greater longer-term gains.
Growth Stocks Pros and Cons
Now let’s take a big picture look at the major pros and cons of growth stocks.
Growth Stocks Pros
- Companies associated with growth stocks are posting consistent current gains.
- Growth stocks are a great addition to a long-term investing strategy.
- Purchasing growth stocks can have an immediate impact on your investing budget.
Growth Stocks Cons
- Growth stocks can be more volatile than the market average, which can take a strong investing stomach
- Growth stocks can fall out of favor during times of fluctuation and lose value more quickly than the market average as a result
- Growth stocks are not going to deliver as much (if any) short term gains in the form of dividends payments, although recent tax law changes have altered this somewhat
What Is a Value Stock?
A value stock, as you may have already guessed, is the exact opposite of a growth stock. A value stock is a stock that is underperforming in context with the stock market average.
If you think of a growth stock like that brand-new high-rise condo that just went up right at the end of the city center, then a value stock is the crumbling bungalow that sits beside it.
Value stocks are easy enough to identify once you know what characterizes their counterpart, growth stocks.
If growth stocks have high price-to-earnings ratio, then value stocks will exhibit – you guessed it – a low price-to-earnings ratio. If growth stocks may be perceived as inflated in value, then value stocks look like hot bargains less observant investors are just leaving on the table.
But before you get too excited about heading out to sleuth out the undiscovered gems just sitting idle on the stock market, consider this: first it is vital to discover the reason(s) why these stocks are considered undervalued.
It may just be they have been eclipsed by their showier rival stocks. But it may also be there is a fundamental issue unfolding with the company’s management, the industry itself or something else that may shed light on a value stock’s long-term potential.
Value Stocks Pros and Cons
Now let’s take a big picture look at the major pros and cons of value stocks.
Value Stocks Pros
- Value stocks are not just “discount” stocks – they are stocks that are perceived as selling for less than what they are truly worth, which makes them a good potential short-term investment.
- Value stocks typically do not deliver the types of wild price swings that can cause investors to panic and overreact.
- Value stocks are definitely easier on the wallet on the front end and can deliver welcome short-term gains in the form of dividends payments.
Value Stocks Cons
- It isn’t always easy to accurately identify value stocks – it can take some digging and industry know-how to find them.
- Value stocks require careful watching to see how the stock performs over the short-term.
- Value stocks that continue to underperform the market or are revealed to have fatal flaws can carry a low liquidity and thus be difficult to offload.
How Growth Stocks and Value Stocks Differ
You already understand the basic differences between growth vs value stocks. But is there more to learn? (Always!)
The first less well-known fact about growth stocks and value stocks is that these terms do not just denote two different classes of stocks. They also describe two different investing styles or strategies.
Growth Stocks Investing
As an investor who is focused on investing in growth stocks, you would likely have these primary goals:
- Long-term profitability is the priority (versus short-term gains in the form of dividend payments).
- Interest in investing in emerging or major industry leaders (later life cycle companies).
- You are willing to pay a premium for growth stocks up front in return for a (relatively) “sure bet” on the back end.
- You have the stamina and financial stability to weather the types of price fluctuations big ticket stocks can generate in the short term.
Value Stocks Investing
As an investor who is focused on investing in value stocks, you would likely have these primary goals:
- Short-term profitability is a priority (dividends payments plus future short-term growth potential).
- Interest in seeking out hidden gems other investors may overlook.
- You enjoy a good bargain and feel confident you can differentiate between the real deal and a losing deal.
- You enjoy researching the stock market, stock performance history, company history and other important data sets you will need to identify promising value stocks.
Finding the Growth vs Value Stocks Middle Ground – Is There One?
It likely hasn’t escaped your notice that the stock market is a pretty dynamic place. Extremes stick out and regularly make headlines.
Wall Street and its counterparts default to taking extreme positions – all good or all bad, all growth or all value.
But is there a middle ground? In other words, do some stocks carry elements of each – part growth stock, part value stock?
As you may have suspected, the answer here is “yes.”
Stock valuations, like all bell curve-derived measurements, represent an aggregate of what is going on in the market at any given moment in time.
If you can picture all the stocks that exist arranged side by side on a bell curve, it is much easier to visualize how there is only room for a certain number of stocks at each extreme end.
The remainder of the stocks will sit somewhere in between.
This is also why both growth stocks and value stocks can have a place in a comprehensive, diversified investment portfolio. This is also why some stocks can go a long way towards meeting both needs with a single stock investment.
In other words, you don’t have to choose only short-term or long-term returns. You can stage your portfolio to receive some of each, understanding that your short-term gains can then be taken as present-day profit or reinvested into your portfolio for long-term growth.
Growth vs Value Stocks: Which Is Better for You?
It can feel frustrating or reassuring to hear that you don’t necessarily need to choose between growth stocks and value stocks when you are building your investment portfolio.
The main reason you might feel frustrated or reassured has to do with your investment timeline and profitability needs.
Here is a real-world example many investors today are facing:
You have started to save for retirement and you have also started to save for your first home. The first goal requires a long-term savings and investing strategy and the second goal requires just the opposite strategy.
You also have a limited amount of free funds to meet both investing goals because you are still paying off student loan debt, paying rent and paying off a car note.
So…what should you do?
Here is where that bell curve we were talking about in the previous section here really comes in handy! Because in fact you can identify and invest into stocks that can potentially generate both short-term and long-term returns for you.
But for very general purposes, it can be helpful to remember these two stock investing rules of thumb:
- Growth stocks are a better choice for a long-term investing strategy.
- Value stocks are a better choice for a short-term investing strategy.
Tracking Growth and Value Stock Indexes
With all this newfound knowledge under your belt, you are probably chomping at the bit to get started with buying stocks. But whether you have your eye on growth stocks, value stocks or a happy midpoint of the two, there is one topic we haven’t yet covered: how to pick your stocks.
Stock picking is both a science and an art. These days, picking stocks is heavily weighted towards science, of course, but you will also bring your personal gut preferences to the table and these also matter.
We will only address the science aspect here. The best way to begin ferreting out the best stocks to add to your portfolio is to pay close attention to stock indices.
Stock indexes are widely used. One well-known example is the S&P 500, which tracks the fluctuations of 500 top stocks and compares them with the industry average.
There are four major types of stock indexes:
1. Geographic stock index
You can track both domestic and international stocks using geographic stock indices.
2. Sector based stock index
Examples of stock sectors might include fintech, biotech, science, health, automotive or consumer goods.
3. Thematic stock index
Common themes investors search for include SRI (socially responsible investing) and ESG (environmental, social, governance).
4. Smart Beta index
So-called “smart beta” indexes are comprised of other criteria that often conforms to certain types of investing strategies.
It may take some initial research to locate the best stock trackers and indexes to use for the specific growth vs value stocks you are seeking.
There are additional indicators you can watch for as well, including major industry trends (an example here would be the sweeping changes in the healthcare industry over the past half-decade), new companies that seem to pop up everywhere “out of nowhere,” new social trends your friends and family are embracing (organic locally-sourced food, ditching cable in favor of streaming packages) and similar indicators.
By keeping your eye on your favorite growth trackers and indices and your ear tuned to new and fading trends, you will be able to gather the best data to use when picking stocks for your portfolio.
Finally, remember that both growth stocks and value stocks – and those that fall somewhere in between on the market bell curve – can have a place in a risk-diversified portfolio. The best way to get started is to thoroughly understand your investing goals first and then build your portfolio to meet those goals.