What's the Difference Between Growth and Value Stocks?

The first half of 2022 has been a turbulent time for stocks. But we didn't need to tell you that. However, something is happening under the surface that you might not have noticed or fully understood.

If you read financial news, you might have seen headlines proclaiming that value investing is back. In fact, in 2021 value stocks outperformed their growth counterparts for the first time since 2016 and for just the fourth time since 2007, according to data compiled by the asset manager Dimensional.

We're here to help explain why this shift in the investment landscape matters.

Let's start by exploring what it means to be a growth or value stock.

Factors in Focus

The two terms are what portfolio managers refer to as "factors." Factors are characteristics that help explain why a stock's price goes up or down. By some accounts, there are hundreds of factors, but value and growth are among the oldest and most enduring of the bunch.

What counts as a value or growth stock typically varies from portfolio manager to portfolio manager. Still, historically, these categories are defined as: value stocks are those that trade at a discount to some fundamental metric, while growth stocks are, as the name implies, associated with companies that are rapidly expanding their sales or earnings. 

For example, a traditional way of identifying value stocks is by evaluating the price-to-book ratio. Price-to-book tells whether a company's market capitalization is higher or lower than the value of the company's assets. 

Logically, you'd assume that a company's stock should trade for more than the total value of its assets. Historically, however, that's not always the case. When the price-to-book ratio is less than one, indicating that the company's assets are worth more than all of its stock, many investors would argue the stock is undervalued. Whether or not that is the case, the idea is that the market will catch on to this discrepancy and, eventually, pay more for the shares. 

On the other hand, the theory behind “growth stocks” is to look at how fast companies are expanding their sales or earnings. Of course, how that's measured can differ from industry to industry. But, as a rule of thumb, if a company's profits are increasing faster than its peers (a group determined by each individual investor), its stock could fall into the growth bucket. 

All else being equal, growth is fantastic. Investors want to see companies make more money. But in reality, that growth might not be sustainable and/or investors may overestimate how much a company will continue to grow. For example, earnings growth doesn't inherently mean a company is making money. Going from losing a lot of money each quarter to losing slightly less would result in positive earnings growth, but more cash is still going out the door than coming in. This can result in investors overvaluing future growth prospects.

Paradigm Shift

With that simple overview out of the way, let's look into why value investing is now outperforming growth.

Some will argue that it's merely a return to historical norms. Dimensional's report shows that value stocks have outperformed growth stocks by 4.1% annually since 1927. That's a long track record to go by, but is it relevant to today? While growth has struggled against value for much of the last century, it has more than held its own over the previous twenty years. 

What might explain that? Here are two possibilities to consider. 

Interest rates were far lower than the historical average during this time. In fact, for much of that time, the Federal Funds Rate has been 0%. This is important for two reasons. When interest rates are low, the net present value of future earnings is higher. Ok, so what does that actually mean? Think of it like this. Investing in U.S. Federal Debt (Treasury bills, notes, and bonds) is considered risk free. Whatever the Fed is willing to pay you for buying U.S. debt becomes the hurdle you have to clear for your investment to be truly profitable. Growth stocks derive their value from expected future earnings. Sometimes those earnings are years away from becoming a reality. In a low interest rate environment, future anticipated earnings are worth more than they are in when interest rates are higher.

Historically low interest rates also meant that it was never easier to fund a company using debt or other outside investments. And many companies, perhaps most notably Amazon, have used this to their advantage. For years, pundits said Amazon had a "profitless business model." In truth, the company was using debt (and equity) financing to keep prices low. In doing so, Amazon believed it could capture a large customer base, knowing that it could eventually raise prices to turn a massive profit. Other companies, perhaps Uber being the most notable example, followed a similar path.

So why is value suddenly back on top? The most obvious answer, albeit an oversimplified one, is that interest rates are rising. At times like this, investors favor companies that can get by without relying on debt. That pivot is a sea change from what we've seen over the last decade. As the Federal Reserve raises interest rates, many "growth" companies appear to be scaling back their ambitions. That typically translates to these companies seeing less growth than previously expected, meaning investors have to readjust their expectations and, with that, the price they're willing to pay for those stocks.

How long this will last is anyone's guess. Suppose you believe inflation isn't going anywhere anytime soon and that the Federal Reserve will continue hiking rates to tame it. In that case, value may have the upper hand for the foreseeable future. However, if the Federal Reserve slows, pauses, or reverses its expected rate hikes, growth could quickly make up the ground it lost over the last two years.

Here's Domain Money founder and CEO Adam Dell's take:

At Domain Money, we're building our clients' wealth for the long run. Right now the market is still grappling with the effects brought on by the global pandemic and the conflict in Ukraine. In the short term, this is causing a rotation from growth to value stocks. But in the long run, we continue to believe that investing in innovation is the secret to building real wealth. Our team is focused on identifying companies that can not only weather the current market storm, but also be the leaders of tomorrow.

Conclusion

Growth and value are two of the most well-known investment styles. Generally, value is considered to be the more conservative approach as investors are analyzing companies as they are today. Growth investing is commonly considered to be riskier than value investing because it requires anticipating how companies will perform at some point in the future. 

That said, for much of the last decade, growth has outperformed value. That’s due in part to a historically low interest rate environment. When interest rates are low, investors can pay more for future cash flows. Now, with interest rates rising in response to inflation, value stocks are once again edging out their growth counterparts. However, if inflation and, subsequently, interest rates were to come down from their current levels, growth could once again reclaim the lead.


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