Growth stocks vs value stocks: which are best?

So why are these two pitted against each other like a Wimbledon match and which one, if either, is better than the other?

What is a growth stock?

‘You’re gonna go far, kid.’

Growth stocks are expected to grow (unsurprisingly) their revenue, profits, etc. faster than the rest of the market. So even if they’re not doing much right now, or haven’t in the past, they’re expected to grow in the future.

They often don’t pay out dividends, management will usually reinvest everything back into the company to speed up short-term growth. Investors expect (hopefully) to make money when they sell their shares later down the line.

Growth stocks are generally considered expensive with their high ‘price-to-earnings ratio’. This is because their earnings are expected to go up in the future though, so they won’t look as expensive then!

It’s can be risky though because if the stock doesn’t end up growing in future, investors may sell their stocks and lose a lot of money.

What is a value stock?

‘Don’t judge a book by its cover.’

Value stocks are those that are priced lower than they should be compared to their fundamentals – they’re the bargain of the investment world.

Value investors will hunt for and buy these undervalued stocks that the market has shunned in the hope that eventually the market will price the stocks appropriately and they will make a lot of money.

It’s like buying a barbecue in winter, when it’s out of fashion and might be cheaper, and selling it for full price in summer on eBay (with less moral questioning attached). But you could lose money if it’s a particularly wet summer!

Value stocks often pay decent dividends so investors can hope to profit from those too.

The risk with value stocks is that the market might decide a value stock was correctly priced all along meaning there’d be no gain to be made on selling later. A stock that’s dropped 50% might bounce back, but it could also stay where it was or even halve again.

Why are value stocks ‘undervalued’?

It can happen for a few reasons. One is behavioural bias – if the market shows a stock to be popular and rising, investors want in, and conversely they want out if an area is doing badly. This herd mentality can affect the price of one single stock.

Other reasons are market crashes; the company not being on-trend enough; or the fickleness of the stock market, reacting dramatically to bad news – shares of companies get caught up in this, so their worth might massively decrease when in reality the company fundamentals or even its performance are not bad.

A deeper look

So which one is better? Now that you have an overview, we can compare them like we do Nadal and Federer, or cats and dogs. We’ll let you decide which is which.

Though unlike a tennis match, past performance is not a reliable indicator of future performance.

Value investing has worked

Over the long term value stocks have outperformed by some distance and cheap stocks have generally bounced back – either the conditions that made them cheap (e.g. an industry or economic downturn) prove temporary or the company’s management figures out a way to turn them around.

This plays on investor psychology – people tend to assume short-term issues at a company will persist, when often they don’t. Investors also tend to get excited about racy new stocks whose share prices are flying ahead, and investing in a company that’s been around forever just because it looks cheap seems pretty dull in comparison.

If value investing works, investors can gain a double benefit. Not only do their profits go up, but this gives investors the confidence to pay higher valuation multiples for them, boosting their share prices further.

Growth investing hasn’t worked historically…

Source: Lipper for Investment Management, June 2021.

In the past fast-growing companies often had that growth wiped out – either the economic conditions that drove the growth vanished, or competitors came in and eroded their profits.

…but it has worked more recently

Source: Lipper for Investment Management, June 2021.

The persistently low interest rates since the Global Financial Crisis (GFC) make future profits more valuable, so investors are more willing to pay up for (possible) profits in 10 years’ time, making fast-growing companies worth more even if they’re not very profitable at the moment. Conversely companies that are very profitable now might be worth less if investors are concerned about where they’ll be in 10 years – think oil companies.

Growth style investing has also been boosted because many growth companies have benefitted from structural growth – growth tailwinds independent of the economic cycle. Most obviously the big tech companies have grown consistently, boosted by the move online, and once entrenched companies like Amazon have proven resistant to competition so far. Conversely value companies have been in industries such as oil, banking and high street retail, all in some degree of decline.

More recently, the pandemic has accelerated some of these trends. Online shopping had been growing relentlessly for years, but stuck-at-home consumers gave it an additional boost, one that seems unlikely to go back.

Value investing making a comeback

Since the introduction of vaccinations and consequent economic bounceback, value stocks have surged. Value stocks can be dependent on the state of the general economy and the return to the physical world

Growth investing vs Value investing

More than one way to skin a cat

And there’s more than one way to generate market-beating returns. Both value and growth styles can be out of favour for years at time, so betting on either style could be harmful – as ever, diversification is important.

Diversification can offer you a hedge against falling markets, since if one sector is performing poorly, the other sectors that feature in your portfolio should help the overall value of your portfolio to not plummet.

Investment risk

Both growth and value stocks carry risk and can go down as well as up, like all investments (and it's wise to remember that you can get back less than you initially invested). Value stocks can be volatile and they’re often economically exposed. However, growth stocks carry a risk too. Buying a company in the expectation of future profits doesn’t work if those future profits never materialise – remember the high-flying internet companies of the late 1990s? Some growth stocks have been hit by corporate scandals, employing dishonest or fraudulent means to create the illusion that they’re still growing. Even the big tech companies might not grow forever – Netflix might be on top at the moment, but how long will it stay that way with Amazon Prime and Disney Plus breathing down its neck? And remember, Nokia and Blackberry were growth stocks at one time!

Quality

It's not an either or. Many of our favourite funds have a growth bias, but we do find attractive value options as well and some managers combine the two – few ignore valuation completely. We believe in looking at the best fund managers, regardless of style.

It is so important too to look at quality – companies with stable revenues and profits and strong balance sheets – such companies are unlikely to go bust or suffer sharp declines, and can deliver strong returns over the long run.

In conclusion

So, as you might have expected, there is no real answer to which style is better than the other. There are a lot of factors that can affect the performance of a stock – growth or value – especially if they’re seasonal (i.e. affected by the time of year/seasons). Like arguing over Nadal v Federer, sometimes it’s better to accept the best and worst of both rather than get into a swinging match of your own…

If you want to get started with investing, take a look at our award-winning ISAs (you can find all our awards here or Best SIPP*. Or if you want to speak to someone about your investments, give us a call on 020 7189 9999 or email best@bestinvest.co.uk.

* SIPPs are not suitable for everyone. If you don’t want to invest across different asset classes or don’t think you will make use of the investment choices that SIPPs give you, then a SIPP might not be right for you.

This article is based on our opinions which may change. It does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact a professional adviser.