Growth vs Value Investing

It is very common among the investment community to see professionals and amateurs alike grouping companies into two large and very broad buckets: growth and value. I’ve often found many people don’t really understand the distinction, and think their portfolio needs to have all growth, or all value, with little middle ground. So, before I even define them, I just want to make it clear that most portfolios should have diverse assets, and a mix of both growth and value companies is going to be appropriate for most people.

The primary difference between the two is somewhat arbitrary, though it can be defined quantitatively (using arbitrary boundaries). A growth company is one that is invests in itself for future growth (research, innovation, new products) and consequently, investors believe it has the potential for higher-than-average returns in the future. In contrast, a value company is usually (but not always) older and more established, invests less in growth because its already profitable, and consequently is undervalued by the market. A good way to think about a value stock is that its “on sale” relative to a growth stock, which might be overpriced because the market believes it has future potential.

Over long time periods, value (lower priced stock) has outperformed growth, however, since the financial crisis in 2008, growth has outperformed by a large margin. It is still up for debate if this shift will withstand the test of time, but from a portfolio perspective, most people that are not completely dependent on their investments for income should own both. Owning large, stable, and potentially undervalued companies, and smaller, growing companies is clearly a form of diversification that will help your portfolio grow, but also provide some buffer when one type of stock is underperforming relative to the other. Arrow uses ETF’s to control allocations of growth and value, though it can also be done on the scale of individual companies as well.

Growth stocks tend to have much higher risk to reward potential. For every Netflix that was massively investing in growth 15 years ago, there are dozens of public companies that either went bankrupt or failed to grow. Therefore, value investing tends to fit with more conservative investors that are targeting consistent returns and steady dividend payments for fixed income. The risk with growth stock is that the company never lives up to the expectations set upon it by the market.

Growth vs Value Stock

Value investors tend to search for companies that they think the market has somehow “missed” the information on. In other words, maybe they had bad PR, or short-term problems, or an outside business issue that the market overreacted negatively too. One of the primary indicators is a low price to earnings ratio (PE), which means their share price is low compared to how much profit they make. In my opinion, people too often consider only the price or PE ratio of a stock to determine if its growth or value. The reality is that it depends on the trajectory of the company and how the CEO and management team are approaching their profits. For example, Apple is notorious for stockpiling billions of dollars in cash and being cautious with how it allocates its money. They often fall somewhere in the middle of the growth vs value spectrum, but they can easily change their position quickly. If they spend billions of dollars increasing dividends, buying back their own stock, and stockpiling cash they are behaving more like a value company. If they use their cash to start new research divisions, buy smaller companies, and enter new emerging tech markets they are behaving like a growth company. The  growth-value spectrum is fluid and it’s not *only* about the stock price; you also need to consider how the company is being managed and what their goals are. People too often focus on some ratios and share prices and don’t really consider what is happening behind the scenes.

Growth vs Value Sectors

Another consideration is that certain industries and sectors lend themselves much more easily to being “growth” or “value”. Consider how a biotechnology or an IT company operates. They need to spend years of development, research, and testing before ever bringing a new drug or piece of software to market. They are forced to be growth companies just by the nature of how the development works. If you buy their stock when they are still in the development phase, you might hit it big when their product becomes successful and permeates the competitive landscape. In contrast, consider financial institutions or consumer staples companies. The major U.S. financial institutions tend to be well established and more naturally lend themselves towards value. So, certain sectors lend themselves one direction or another. However, that is just a guideline that won’t always work in reality. Johnson and Johnson might be part of the same sector as a pharmaceutical company developing a new drug, but their placement on the growth/value spectrum is quite different.