Investors often encounter the terms value stock and growth stock. Perhaps you participate in a 401k that offers mutual funds that invest in one type of stock or the other. The terms may seem confusing. How can a stock be a good value unless it produces growth?
Even authors of investment books can misinterpret these terms. One book published recently says a value stock is “a stock that investors believe is trading for less than it is worth for a variety of reasons, including the perceived undervaluation of its assets.” That’s just so wrong. Stocks never trade for less than investors believe they are worth. Based on the rest of his work, the author who penned those words appears to be knowledgeable, so I’ll assume this definition arose from a momentary brain cramp, a phenomenon with which I’m all too familiar.
To understand the actual distinction, consider the stocks of two different companies that are currently producing the same level of earnings. One of them appears to have excellent prospects of making those earnings grow rapidly in the near future. The other has less favorable prospects. For one reason or another, it seems likely that its earnings will stagnate, or perhaps even decline.
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Naturally you would pay more for the stock that seems poised for greater success. Depending on the strength of investors’ belief in rapid growth, they might place the company’s overall value at a level that’s 30 or 40 times the current earning level, or higher. A price this high can’t be justified in terms of current earnings; the price makes sense only if those earnings are set to grow rapidly. A high ratio of the stock price to current earnings — the price/earnings ratio, or P/E ratio — tells us that investors are counting on growth, so this is a growth stock.
If the company produces the expected growth in earnings, this stock will turn out to be a good investment. In terms of its current earnings, however, the stock is not a good value. With a P/E ratio of 40, for example, the current earnings will produce a return of only 2.5% per year, far too small to justify the risk of stock investing.
The other stock, though, the one where the company appears to have little forward momentum, is selling for a lower price. Investors might have priced it at 10 times current earnings or even less, meaning that today’s profit level would produce a return of 10% per year or more. This is a value stock, not because it’s trading for less than it’s worth (the low price indicates investors believe the stock is worth relatively little) but because you pay less money relative to the current level of earnings.
A growth stock doesn’t necessarily make your money grow: if the company disappoints investors who are expecting higher earnings, the stock price will fall. Likewise, a value stock won’t necessarily protect the value of your portfolio: the low price means investors are expecting hard times for the company, and things can go from bad to worse.
On average, over the long term, value stocks have outperformed growth stocks, especially among smaller companies (“small caps”). This is most likely because value stocks expose investors to greater risk. Growth stocks involve risk because they must produce higher earnings to justify their higher price, but the risk of investing in a company that’s struggling to produce profits is even greater.
Nevertheless we go through periods, sometimes extending years, when growth stocks outperform value stocks. There’s no reliable way to predict which category will produce the best results in any particular period. The best approach is to make sure your stock portfolio includes both. If you have a good appetite for risk you can tilt a bit toward value, but bear in mind that it may take many years for this approach to pay off, and you’ll be exposed to somewhat higher risk in the meantime.
