Growth vs Value Investing

Growth and value investing are two distinct strategies focusing on different stock types. Growth investing targets companies with high potential for earnings growth, typically found in sectors like technology and communication services, characterized by high price-to-earnings ratios and volatility. Value investing, on the other hand, seeks stocks trading below their intrinsic value, often in sectors like finance and energy, marked by low price-to-earnings ratios, high dividend yields, and lower volatility.

Where growth investing looks forward to investing in companies that are increasing their revenue, profits, or cash flows at a faster-than-average tempo, value investing seeks out older companies that are priced below their intrinsic value.

In the complex world of investing in the stock market, there has been a long standing debate on value investing vs growth investing. Choosing right stocks is an art as well as science and among the various investment approaches, growth investing and value investing are quite popular. Investors adhering to one of these two approaches have their own reasoning and philosophy on why value investing is better than growth investing and vice versa. Let us understand the key points of distinction with examples that will help you choose an approach as per your investment style.

What is growth investing?

The fundamental philosophy surrounding growth investing is ‘capital appreciation’. Growth investors typically invest in companies that show high potential in terms of above-average growth in revenue, profit, or cash flows. Thomas Rowe Price, Jr. has been called the ‘father of growth investing’. Also, Phil Fisher was instrumental in shaping the growth investing style.

Growth investors usually target stocks priced at Rs. 500 that could potentially reach Rs. 1000 in a few years if the company continues to grow quickly. This investing style identifies young companies that can quickly multiply in value over a period of a few years. Since sustained growth and capital appreciation are the fundamental tenets of growth investing, growth investors do not prefer stocks that pay high dividends. Instead, companies which reinvest most of their profits into the business are the favourites of growth investors. Investors need to be cognisant of the life cycle of companies to follow growth investing. An important condition for this style to work is that the company must continue growing and the market circumstances should continue to price growing companies at premium valuations at a later stage if the company succeeds.

Also referred to as ‘momentum stocks’, growth stocks continue to attract more investors on their growth path which can sometimes lead to a crowding effect even if some stocks are not fundamentally strong. This is because investors expect growth stocks to run in a few years. This may not necessarily happen because of which growth stocks can lose their valuations.

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What is value investing?

In contrast to growth investing, the value investing philosophy can be summed up as ‘capital preservation’. Value investing focuses on identifying fundamentally strong stocks that are priced below their intrinsic level. While a growth investor looks out for stocks priced at Rs. 500 that could attain a price of Rs. 1000 in the near future, value investors target stocks that are actually worth Rs. 500 but priced at Rs. 50 today. Investors such as Benjamin Graham, Charlie Munger, and Warren Buffet belong to this school of thought.

Therefore, value investing targets fundamentally strong companies that are currently undervalued and off the radar for most of the investors. The expectation is that once the market perception becomes more favourable, the stock prices will show a sustained and substantial increase. The entire focus in value investing is buying stocks at prices lesser than their intrinsic prices which eliminates companies that are overvalued.

Stocks that are priced around the intrinsic prices can still fit the bill. A prerequisite for value investing is a strong understanding of company financials and macro trends. Stocks identified as a part of value investing strategy must have a decent growth rate, substantial profit margins, a low P/E ratio, low debt, and a high free cash flow. Since a value investor seeks out fundamentally good stocks, value investing is less risky than growth investing.

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Differences between growth investing and value investing

The following table summarises the characteristics of growth vs value investing:

Features of the stock	Growth investing	Value investing
Philosophy	Invest in high-growth and young companies that are aggressive in the market and repeatedly outperform their rivals.	Invest in fundamentally strong companies that are currently at lower valuations due to the cyclical nature of the sector or unfavourable market conditions
Target companies	Rapidly growing companies that beat the growth rate of their business segment or the overall market	Fundamentally sound companies that are mature and established market players available at dirt cheap prices
Price of stock	High	Low
Volatility	Higher	Lower
Dividend	Low or no dividends expected, frequency of dividends is less often	Sustained dividends expected, frequency of dividends is more often
Valuation (P/E ratio)	Higher	Lower
Popularity	All in favour stocks	All out-of-favour stocks
Level of risk	High-risk strategy because of the volatility associated with companies in early stage or growth stage	Low to medium risk strategy because of the lower volatility for mature stocks, volatility may still occur due to a bad economic cycle
Representative companies	Zomato, Amazon, Bajaj Finance	State Bank of India, Coal India Ltd.
P/E ratio	High	Low
P/B ratio	High	Low
Investment horizon	Usually longer	Usually shorter
Performance in different market cycles	Usually outperform value stocks in bull markets	Usually outperform growth stocks in bear markets

Growth vs. Value Investing: A Detailed Breakdown

1. Growth investing

Growth investing is typically riskier and requires a higher risk appetite on the part of an investor. Several high-growth companies could eventually turn out to be laggards or dwarfs, and therefore, it is essential for investors to hedge against risks in this high-risk high-reward strategy. The investment horizon is very long which means that investors cannot churn their portfolios frequently.

High growth companies do not offer dividends regularly, and therefore, investors who are seeking periodic returns should never adopt the growth investing style. As expected, growth stocks are bought at a premium price and their P/E and P/B ratios are always on the higher side. This also represents that the market currently over values such growth stocks compared to their book values. Growth companies usually leverage high-end technology to surge ahead of competitors. They are characterised as being innovative, ecosystem-builders, and trendsetters.

Initially having a competitive advantage, these companies usually build several defences or moats as they progress along the life cycle because a single competitive advantage can be imitated by competitors. By adopting this playbook, they ringfence their ecosystem of businesses against challengers. It also means that they have to invest a lot of money into their core operations, R&D, and business expansion during their early and growing stages which translates to lower dividends for investors. These companies are investor darlings and everyone in the market likes to invest in their growth journeys resulting in a higher stock price. These stocks are susceptible to extreme volatility.

2. Value investing

The value investing approach involves a lower level of risk as the fundamentally solid stocks typically exhibit a sustained growth. Generally, value stocks are established players in a particular sector and they have navigated different business cycles, shifting consumer preferences, and dynamic regulatory environments while making steady progress.

A consistent growth rate and sound financials also mean that they can pass on their earnings from business to investors in the form of regular dividends. Value stocks usually have lower debt levels except for stocks in capital-intensive sectors. Lower debt levels protect strong businesses during an adverse economic environment such as higher interest rates on borrowings. The value investing style will suit investors who are seeking regular returns as well as steady capital appreciation. Identifying and betting on value stocks that are currently available at discounted prices involve studying the macro environment, sector outlook, financial statements, company leadership profile, etc.

A defining feature for value stocks is that they should be currently not in the investing basket for most investors. They should also be perceived to be lower in value resulting in a lower P/E ratio than the category average. Industry leaders can be value stocks if their valuations are currently low and they are available at a bargain price.

We can see that the value investing vs growth investing approaches are rooted in psychology and historical perspectives on returns generated can provide further insights.

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How have growth vs value stocks performed in past

Generally, value stocks have generated higher returns in bull markets and in periods of economic downturns such as recession. On the other hand, growth stocks have offered more returns in bear markets and during periods of economic expansion. Historically, on a long-term basis, value stocks have usually outperformed growth stocks but on the short-term, growth stocks have surged ahead of value stocks.

Examples of growth vs value investing

1. Growth investing

Growth stocks are typically those stocks that are yet to experience multiple business cycles. These stocks usually have a distinct competitive advantage in terms of product or technology and do not come under the category of consumer essentials. These grow their business more rapidly than the market average. Some typical growth stocks in India would be Bajaj Finance, Reliance Industries, Zomato, etc. In the US context, this would be stocks such as Amazon, Netflix, Tesla, etc.

2. Value investing

A key trait of value stocks is that they have been exposed to severe economic volatility. These are usually companies that a consumer needs during all economic weathers - good and bad. Some examples in the Indian context would be Power Grid Corporation of India, Coal India Ltd., State Bank of India, Bharat Petroleum Corporation Ltd., etc. Similarly, Procter & Gamble, JPMorgan Chase, etc, are some value stocks in the US.

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Which is better growth investing or value investing?

Each investing style outperforms the other in different market conditions. During a period of low interest rates, growth stocks do better. When the rates start increasing, investors reallocate their portfolio to value stocks. A reason for this could be that growth stocks are highly leveraged during their growth stage and a period of lower interest rates increases their profitability. A high interest rate means higher borrowing costs which drive down the profitability of growth stocks.

1. Growth stocks continue to outperform

The external macro environment has become extremely volatile and investors prefer staying invested for a longer term in growth stocks. Market disruptions like the COVID-19 pandemic have caused fundamental shifts in consumer behaviour. Technology-driven companies that have capitalised on this shift have reaped benefits while the traditional value stocks have not been rewarded. However, it is important to note that the overall business environment has favoured growth stocks.

2. Value investing tends to outperform over the long term

There has been ample research proving that value stocks tend to outperform growth stocks over a longer timeframe such as several decades that see multiple business cycles. So, value investing seems to be a more tried and tested strategy for someone who does not want to take more risks but still wants to generate a sustained return on his capital.

Also read: Understanding the time value of money

When will value outperform growth again

The next trigger for value stocks outperforming growth stocks again is likely to be a period of sustained inflation when consumers tend to allocate more to necessities. Going by analysts’ predictions, RBI is expected to cut interest rates which will boost the economy further. So, typically, in a bull market, growth stocks are expected to perform better than value stocks. It is only when price levels rise to an extent of general inflation will the value stocks tide over the bad phase and outperform growth stocks.

Conclusion

Growth vs Value Investing are two distinct approaches with their own flavours. The debate may never end but on a long-term basis, it is generally observed that the value investing style has generated higher returns than the growth investing style. However, their performance depends on several factors such as market conditions, business performance, consumer sentiments, regulatory changes, and macroeconomic variables among others. Investors should not choose value stocks that will underperform always, thereby avoiding a ‘value trap’. A similar caution also holds true for value investing - avoiding high-growth companies that ultimately bite the dust. So, there is no one-size-fits-all approach and investors should make an informed investment decision considering their risk appetite and financial goals.

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