Everyone hears over and over, from Morningstar and other sources, about value versus growth investing. The problem, and reality is, that most investors simply don't understand the difference between the two philosophies. Notice that I did not say between the two different kinds of stocks. Why? Well, because stocks can float between the two categories based on certain fundamentals. In this article, we?ll articulate the differences between value and growth investing.
Value investing is the strategy of selecting stocks that trade for less than their intrinsic value. Value investors actively seek stocks from companies with sound financial statements that they believe the market has undervalued. As such, value investors are not one hundred percent believers in the "efficient market hypothesis," which maintains that the current market price of a stock reflects all the currently "knowable" information about a company and, so, is the most reasonable and rational price for that stock at that given point in time. In fact, one of Warren Buffett's (Benjamin Graham's student and one of the most famous value investors of all time) sayings is that "in the short run the stock market is a voting machine, but in the long run it is a weighing machine." Value investors tend to put more weight on their judgments about the extent to which they think a stock is mispriced in the stock market. If a stock is under priced, it is a good buy; if it is over priced, it is a sell. Oftentimes value investors seek to buy stocks that are depressed because their companies are going through periods of difficulty. They would then ride their prices upward, if and when such companies recover from those difficulties, selling them when their fair value is reached.
According to most sources, investing for value typically means purchasing stocks that are trading at relatively low price-to-earnings (P/E), price-to-book (P/B), and price-to-sales ratios (P/S) and have relatively high dividend yields (dividend yield is calculated by dividing the company's annual dividend payment per share by its current share price). In fact, according to Morningstar and their "style box" definitions, "Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow)."
Investing for "growth" results in just the opposite - stocks trading at high P/E, P/B and P/S ratios and relatively low (or no) dividend yields. A growth investor seeks out stocks with what they deem good growth potential. In most cases a growth stock is defined as a company whose earnings are expected to grow at an above-average rate compared to its industry or the overall market. Again, according to Morningstar, "Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields). Most of these portfolios focus on companies in rapidly expanding industries."
Although, in general, value stock portfolios tend to hold up better during stock market downturns, this in large part depends on the specific makeup of the investor's portfolio. For example, if the stock is considered a value stock and has typical value stock fundamentals because the company is producing a product that is fast becoming obsolete or because the company is having serious financial issues, then a recession could put that company out of business. On the other hand, a value stock that has become a value stock simply because it is not growing revenues at a 20% compounded rate per year (although it is producing strong free cash flow) and is overlooked by greedy investors, can be a great holding during downturns. There were many of these stocks available in the late 1990's (however, it is notable that there are far fewer available today). For anyone who truly wants to understand value, we recommend two books by Benjamin Graham (the father of value investing); Securities Analyses: The Classic 1940 Edition and The Intelligent Investor Revised Addition (with commentary by Jason Zweig).