Analysts like to separate stocks into two categories: value and growth. What is the difference between value stocks and growth stocks, and which style provides better returns?
There is no exact definition explaining the difference between value stocks and growth stocks, but each has its own distinct characteristics.
In general, value stocks have low price ratios and growth stocks have high price ratios. Value stocks as a whole have been shown to outperform growth stocks over time.
The low price ratios of value stocks are a result of investors being cautious about the future of the underlying companies. Similarly, the high price ratios of growth stocks are a result of investors being excited about the future of the underlying companies.
While discussing mutual fund investing using either growth or value stocks, Fidelity says the following:
Growth funds focus on companies that managers believe will experience faster than average growth as measured by revenues, earnings, or cash flow.
The goal of value funds is to find proverbial diamonds in the rough; that is, companies whose stock prices don’t necessarily reflect their fundamental worth.
In the stock market, companies are valued based on future expectations.
Wonderful vs. Weak
If a company’s growth begins to slowdown or its profits start to decrease, the result will be a lower share price. Value stocks are typically companies with recently poor operating results and negative outlooks.
The weak performance could be due to macroeconomic events or company specific challenges. It could be a temporary setback or a major loss of market share.
If a company is growing and its profits are increasing rapidly, the result will be a higher share price. Growth stocks are typically companies with recently phenomenal operating results and bright futures.
The wonderful performance could be due to a rising tide in a particular industry or great management of a specific company.
If growth stocks are “wonderful” and value stocks are “weak”, how can value stocks be better investments than growth stocks?
It turns out that human nature causes value stocks to provide better long-term returns than growth stocks. People get too excited about growth stocks and too afraid of value stocks.
While discussing the recent trend of investors moving away from value opportunities,Morningstar’s Ben Johnson said:
What we’ve seen historically is that it’s exactly this sort of capitulation, this sort of behavioral function that may actually lead to the existence, the creation, the persistence of the value premium. Value exists because there are suckers on the other side of the poker table willing to take the flipside of the value bet. They are betting on growth or something else. Real, true, strong hands at that poker table, in all likelihood will continue for many years to come, to reap the benefits of that value bet, assuming that they are strong hands.
The optimism towards growth stocks makes them overvalued. The pessimism toward value stocks makes them undervalued. Investors become overly confident about a growth stock’s future and overly scared about a value stock’s future.
Through a phenomenon called herd behavior, human nature causes a gap to occur between the value of a stock and its price.
Herd behavior says that “individuals in a group will act collectively without centralized direction.”
In Thomas Howard’s book, Behavioral Portfolio Management, he talks about how following the crowd is an evolutionary trait. It was beneficial at one point but now does more harm than good, especially in investing. Howard says:
Doing the same thing as everybody else, the definition of social validation, also made sense thousands of years ago when life was full of danger. Since we lived in small groups then, we depended on others to sense danger and react instinctively. You didn’t want to be the slowest member of the group when fleeing the tiger. In contrast, today we frequently want to take positions different from the emotional crowd as a way to harness the price distortions resulting from collective behavior.
Because the stock market is nothing more than a group of individual investors, heard behavior is a common occurrence.
No investor wants to be left behind. As prices start climbing, everyone wants to jump on board. This results in the high valuations of most growth stocks.
Once prices start falling, investors dump the underperforming stocks in mass. This results in the low valuations of value stocks.
It’s important to refrain from following the crowd and to avoid investing in undervalued stocks rather than overvalued stocks.
The Difference Between Value Stocks and Growth Stocks
A summary of the difference between value stocks and growth stocks is:
- Value stocks are undervalued, out-of-favor companies with recently poor operating performance and slowing growth. Investors overreact to these stocks and value them lower than they should be.
- Growth stocks are overvalued, “hot” companies with recently great operating performance and rapid growth. Investors overreact to these stocks and value them higher than they should be.
Understanding the difference between value stocks and growth stocks will allow investors to profit greatly over time. At TheStockMarketBlueprint.com, investors can use the pre-determined stock screens to find values stocks and build long-term wealth.