Investing in equity is the classic way of setting up your portfolio for capital gains. But there are two different ways you can do this: growth investing and value investing. Read on to know which road you should take.
They often say that there are two types of people in the world: Those who look at the glass as half full and those who look at it as half empty, those who like pineapple on their pizza and those who don’t, those who have their WhatsApp blue ticks on and those who don’t. We all love to simplify the world by splitting it into two. And the world of stock market investing is no different, where investing styles are often bifurcated into two distinct types – growth investing and value investing.
Let’s look at each of these classic investing styles to help determine which category you belong to and what kind of stocks you should add to your portfolio.
What are growth stocks?
Growth stocks are stocks of companies that are expected to grow at a rapid pace and outperform the industry average in terms of sales and earnings. Typically, technology stocks and consumer discretionary stocks are considered growth stocks. Some examples of growth stocks include Amazon, Tesla, Etsy, and Shopify.
To understand growth stocks better, let’s look at some of their common features:
- Growth stocks often belong to companies that have some sort of economic or competitive advantage, such as a unique product line or proprietary technology. This allows them to outpace other companies in the industry.
- Usually, growth stocks do not pay dividends. Instead, they tend to reinvest their profits to accelerate the growth and expansion of the company.
- Since growth stocks do not pay dividends, the only real opportunity that investors have to earn through growth stocks is through capital gains, i.e., when they sell the stock in future at a higher price.
- Price-to-Earnings (P/E) ratio is an important indicator of how the company’s shares are priced with respect to their inherent value. Growth stocks tend to trade at high P/E ratios as investors expect the stock price to grow rapidly in the future.
- You can find growth stocks across all market capitalisations – small-cap, mid-cap, and large-cap.
Growth stocks are often compared in contrast with value stocks. Let’s see why that is.
What are value stocks?
Value stocks are stocks that trade at a price lower than what the corresponding companies’ financial fundamentals would suggest. This means that these stocks are undervalued even though the company’s sales and earnings are strong. Sectors such as financials, energy, consumer staples, and industrials are typically considered to be value sectors. Berkshire Hathaway, Procter & Gamble, and Target are examples of value stocks.
Some common features of value stocks include:
- Value stocks are often stocks of prominent, established companies whose shares are undervalued due to a specific reason in the short term. For example, these could be negative publicity, legal problems or macroeconomic factors.
- Since the stocks are undervalued due to adverse events in the short term but have strong financial fundamentals, investors often see them as a good bargain.
- Value stocks trade at low P/E ratios and allow investors to add good stocks to their portfolio at discounted prices and enjoy low but stable capital gains in the long term.
- Typically, value stocks have a stable and robust dividend-paying history and can be relied upon for dividend income.
Value stocks and growth stocks tend to perform differently in different market conditions, and each carries specific risks.
Growth vs value stocks: Which to pick?
Both growth and value stocks present good investment opportunities. If you use the best trading apps, then you can benefit from both categories by gaining access to all the top growth and value stocks in the global markets.
However, to understand which category you should invest in, it’s essential to consider their performance and the risks involved.
Considering the US stock market, value stocks have typically outperformed growth stocks over a long-term horizon. Value stocks also tend to perform better in bear markets and periods of inflationary pressure, as seen in the latter half of 2022. The Russell 1000 Value Index fell 9.58% last year, while the Russell 1000 Growth Index plunged 29.81%: a difference of almost 20%! This is the largest margin of outperformance since 2000.
It’s important to note that growth stocks tend to be sensitive to rising interest rates, and the Federal Reserve adopted a particularly tight monetary policy last year to curb inflation. Conversely, growth stocks tend to outperform value stocks when the markets are bullish.
Both growth and value stocks come with a certain level of risk. Growth stocks typically come with higher metric ratios like P/E, while value stocks trade at lower metric ratios, and investors invest with an expectation that the market will correct their prices. In the event this does not materialise, investors will have to take a hit. However, value stocks experience lesser price volatility as they often belong to large, established companies. At the same time, value stocks often tend to pay dividends, which growth stocks do not.
The best of both worlds
So now we come to the million-dollar question: which of these types of stock should you buy? And, as is usually the case in the world of investing, there is no one-size-fits-all answer: it depends on your age, savings, circumstances, risk appetite, existing investments, etc.
But here’s the best part: you don’t have to pick one or the other! Instead, you can simply add both growth and value stocks to your portfolio. In fact, legendary investor Warren Buffett, who is also one of the most famous value investors, once pointed out in a letter to his shareholders that both investing approaches are joined at the hip.
Nevertheless, diversification is also key. So regardless of which style of investing you decide to go with, make sure you’re not concentrating too much of your portfolio in one or two stocks. By investing in a variety of different stocks, you can spread out your risk and potentially increase your returns over the long term. Ultimately, remember that building a well-rounded investment portfolio takes time, patience, and a commitment to ongoing education and research.