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One of the most common distinctions drawn in the world of stock investing is that between growth and value. These labels are routinely applied to individual stocks, market sectors, indexes, investors and mutual funds. Put simply, the growth investment style seeks companies whose earnings are expected to grow faster than the broad market, while the value style seeks stocks that are believed to be priced below the companies’ actual values. Wise investors understand the differences between the two, but the wisest know that a portfolio built around both growth and value stocks can be the true path to investing success.
What the Style Labels Mean Sorting It All Out Variations on Growth and Value Helping Your Portfolio Go With the Flow Growth and Value Mutual Funds
“The list of factors that can be considered a determinant of either growth or value characteristics is not limited, and there is very little agreement among researchers or analysts about which set of variables is most important.”*
* S&P US Style Indices Index Methodology, April 2006, pg. 7.
What the Style Labels Mean
It would be difficult to talk about growth and value investing without first establishing what differentiates a growth stock from a value stock. The characteristics that typically distinguish each group are mostly taken from measurable data. But investors must keep in mind that additional, non-quantifiable factors such as market sentiment can sometimes blur the line between the styles. Generally speaking, growth companies have a track record of higher-than-average earnings growth, and investors are willing to pay higher share prices for their future growth potential. This potential also represents the main risk of growth stocks because if earnings growth does not occur as expected, the share price may decline. Value companies generally exhibit slower growth and sell at lower prices. A stock is only a true value if the company is fundamentally sound and its share price depression is temporary. Following are some general guidelines used to identify each type of stock: Characteristics/Risks of Growth and Value Stocks
Growth Stocks Characteristics • High rate of growth in earnings/sales • High price/earnings and price/book ratios • Pay lower or no dividends Value Stocks • Lower rate of growth in earnings/sales • Low price/earnings and price/book ratios • Higher dividend yields • Turnaround opportunities Risks • Future growth does not occur as expected • Price/earnings or price/book ratios decline unexpectedly • Evaluation of stocks as “good value” is misread • Difficult to stick to value policy when prices are beaten down
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known as Growth at a Reasonable Price (GARP). or perhaps they simply haven’t yet recognized the growth potential of the new technology. while others look for relative value. some investors focus on absolute value (as measured by P/E and P/B ratios). This generally may be the case. while the ratios for value stocks are almost always lower. however. this is not a true value stock because the company is not fundamentally healthy and its share price is unlikely to recover.Sorting It All Out While there is no universal formula for determining whether a stock should be categorized as growth or value. an analysis usually begins with the stock’s price/ earnings (P/E) ratio and/or its price/book (P/B) ratio. recognize good investments when they come along and not miss out on opportunities because of style labels. The P/E ratio is the current stock price divided by current earnings per share (i. This approach. but not necessarily. Growth stocks typically exhibit higher P/E and P/B ratios. Some investors. Sometimes a growth stock can masquerade as a value stock. the multiple of earnings at which the stock is selling). Selecting stocks based on a single measure. The key to successfully navigating these anomalies is to do research. such as its P/E ratio. Graham and Dodd were professors at Columbia Business School who pioneered value investing in the 1920s. There are also different approaches to growth investing.e. Consider a company with desirable products and reliable markets whose share price is depressed because conflict among management has hindered productivity. The bottom line is that the current price of a stock is far less informative than its relationship to the measurable value of the company. Growth stocks can pose similar challenges to the style-minded investor. Given all that’s been said. take the view that a growth stock is only worth buying if the price is reasonable. Most large-scale investors and fund managers of both styles rely heavily on fundamental research to uncover strong companies that represent good investments. Even at its lower share price. say a relatively new company has developed a promising piece of technology.. The company’s stock may be undervalued for a time because investors are wary of the company’s short track record. For example. A relative value approach may compare a current indicator like the P/E ratio to the company’s own historical P/E ratios. as they can sometimes sell quite cheap relative to their earnings potential. . one might suspect that growth stocks are expensive and value stocks are cheap. Using a relative value approach. or to the ratios of other companies in the same industry. The P/B ratio is the current stock price divided by the company’s book value (total assets less total liabilities). is essentially a hybrid of growth and value investing. it is even possible to find growth stocks that are relatively undervalued versus their peers. Today. can be very risky. Variations on Growth and Value Value investors use methodologies based on the original teachings of Benjamin Graham and David Dodd. The core growth philosophy argues that a high stock price does not matter if the company’s growth prospects are sufficient.
Although growth stocks were strong from 1995 to 1999 and provided superior returns in both 1998 and 1999. It is not possible to invest directly in an index. during the years preceding the bear market of the early 2000s. it can be especially difficult for an individual investor to achieve a balanced portfolio with adequate exposure to the two styles. The S&P 500 Index is an unmanaged index that consists of the common stocks of 500 large-capitalization companies. Fund managers have extensive research capabilities. Value stocks took a beating as well. If you have questions. It is nearly impossible to predict when those phases will change. The most important thing is to be sure you know how a fund invests before you invest. Value and growth stock performance moves in phases because the business cycle affects growth stocks and sectors differently than it would their value-oriented counterparts. The Russell 1000 Growth Index is a subset of the Russell 1000 Index that consists of those Russell 1000 securities with higher price-to-book ratios and higher forecasted growth rates. Growth vs.and value-styled mutual funds. For illustrative purposes only and does not represent any particular investment. most of which are listed on the New York Stock Exchange. it is important to own both value and growth stocks in a diversified portfolio. If you look at the chart as a whole. Large-Cap Growth is represented by the Russell 1000 Growth Index.Helping Your Portfolio Go With the Flow So which style is right for your portfolio? The answer is: both. Historically. Diversifying across equity styles may also help to mitigate some of the risk of investing in either of these asset classes in isolation. Learn before you invest! 40 20 0 Russell 1000 Growth Russell 1000 Value S&P 500 -20 -40 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Sources: BlackRock. Large-Cap Value is represented by the Russell 1000 Value Index. BlackRock offers growth and value fund options diversified among large and small caps. they plunged with the bear market in early 2000. Performance does not reflect any fees. The Russell 3000 Index is composed of 3. within various industrial sectors. Smart investors embrace both styles in order to maximize return potential and effectively manage risk in a well-balanced portfolio. representing approximately 98% of the US equity market. call your financial professional or the fund company to get answers. Growth and Value Mutual Funds Since even the professionals can’t agree on hard-and-fast guidelines to identify growth versus value stocks. and even international stocks. but to a lesser degree as compared to growth investments. you will notice that growth and value have each taken the lead at different points in time. The Russell 1000 Value Index is a subset of the Russell 1000 Index that consists of those Russell 1000 securities with lower price-to-book ratios and lower forecasted growth rates. growth stocks have performed better when the economy was prospering. The Russell 1000 Index consists of the largest 1. Past performance is no guarantee of future results. or climbing out of.000 large US companies ranked by market capitalization. expenses or taxes. a recession. One excellent way to achieve such diversification is by investing in growth. while value stocks tended to take the lead when the economy was in the midst of. Value Over the Years 60% Growth and value tend to outperform during different phases of the business cycle. Since it is very difficult to predict when the phase will change. PSN Enterprise. An example of this can be seen in the chart below. .000 companies in the Russell 3000 Index. though. and the size of a mutual fund allows it to hold a more diversified group of stocks than an individual can usually afford. but their overall performance has been relatively equal for the past 20 years. and you probably will. Ask for a prospectus and read it.
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