At different times, the stock market appears to favor one of two stock types: value stocks or growth stocks. Since the 2008 market downturn, for example, the market has primarily favored growth stocks. However, for the first decade of this millennium, value stocks were on top.
Since the media often focus on value vs. growth, it can be helpful to understand this distinction. Still, remember that we always recommend you invest in a diversified mutual fund portfolio.
What Is Value Investing?
The idea behind value investing is, essentially, bargain hunting. Value investors look for stocks that they believe are being undervalued by the market. If they consider a stock to be underpriced, it’s an opportunity to buy. If they consider it overpriced, it’s an opportunity to sell. Once they purchase a stock, value investors seek to ride the price upward as the security returns to a fair market value, selling it once it gets there.
To determine a value investment, investors may examine the company’s balance sheet, financial statements, and cash flow statements to get a clear picture of its assets, liabilities, revenues, and expenses.
The balance sheet does not tell a company’s full story, so there is no guarantee that a stock will appreciate as much as an investor expects. A stock an investor believes to be undervalued may remain undervalued or even drop in value.
What Is Growth Investing?
Growth investing attempts to use today’s information to identify tomorrow’s strongest stocks. The idea is to look for stocks of companies that are expected to experience substantial growth.
Growth investors seek companies in a position to generate revenues or earnings greater than what the market expects. When growth investors find a promising stock, they buy it, even if it has already experienced rapid price appreciation, hoping that its price will continue to rise as the company grows and attracts more investors.
While growth investors may examine a company’s value, their choices typically follow other criteria. Growth investors are more concerned about whether a company is exhibiting behavior that suggests it will be one of tomorrow’s leaders; they are less focused on its underlying value.
For example, growth investors may favor companies with a sustainable competitive advantage that are expected to experience rapid revenue growth, be effective at containing cost, and have an experienced management team in place.
In contrast to value investments, growth investments may have an above-average price-to-earnings ratio (PE ratio). And they may, in some cases, be prone to higher volatility than value investments. This high price-to-earnings ratio may indicate a growing company, or it could indicate that investors have become overconfident in the company’s future performance. These investments are typically bought at an already high price, and there’s always a risk the price will stagnate or fall.
Value investors and growth investors share a common purpose: to buy low and sell high. The key difference between these two approaches is this: value investments are believed to be underpriced now, while growth investments are expected to command higher prices in the future. Both approaches assume that the value of the stock will rise, but for different reasons.
For your own portfolio, most people find that proper diversification of their portfolios requires a mix of value and growth investments. Work with your investment advisor before making any decisions regarding your portfolio.
Confused about how you should invest? Set up a call to discuss how we can help.
This content is developed from sources believed to be providing accurate information and is provided at least in part by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Original content of Practical Financial Planning, Inc. only is copyright © 2021 by Practical Financial Planning, Inc.