Subject: Strategy - Value and Growth

Last-Revised: 26 Dec 2007
Contributed-By: Chris Lott (contact me), Steve Selengut (contact me)

Investors will frequently read about growth stocks and growth strategies, as well as value stocks and value strategies. These terms describe reasons why people believe certain stocks will increase in value. This article gives a brief summary of the investment strategies centered upon finding those stocks.

The value strategy attempts to find shares of companies that represent good value (i.e., value stocks). In other words, their stock prices are lower than comparable companies, perhaps because the shares are out of favor with Wall Street. Eventually, they believe, the market will recognize the true value of the stock and run up the price. People who believe in this strategy are sometimes called fundamentalists because they focus on the fundamentals of the company. The grand champion of this strategy is (was) Benjamin Graham, author of two classic investment books, Security Analysis and The Intelligent Investor.

The growth strategy attempts to find shares of companies that are growing and will continue to grow rapidly (i.e., growth stocks). In other words, their earnings are increasing nicely and the stock price is increasing along with those earnings. People who believe in this strategy are sometimes called momentum investors. They are sometimes criticized for paying high prices for growth and ignoring

fundamentals. Measures of growth usually focus on the earnings growth.

You might think that there is a pretty clear distinction between value stocks and growth stocks. Unfortunately this is not the case. Many investors think of value stocks as generally conservative investments because the companies are large and stable. Value stocks, you will hear, are those that have a good expectation of price appreciation for any of the following reasons:

  • Are considered to be undervalued because the stock price does not reflect the company's true value. A company might be considered undervalued based on criteria such as price/earnings ratio, price-to-book ratio, dividend yield, revenue, brand recognition, etc., etc.
  • The stock has been out of favor (not recommended by investment advisors to their clients) and therefore shares are relatively cheap compared to the value of the company's assets.
  • Trade at a P/E ratio lower than the market average P/E ratio as a result of falling prices rather than improving fundamentals.
  • Are trading at a lower price relative to their fundamentals compared to growth stocks.
Therefore the distinguishing feature of value stocks is price. How does the price of the stock relate to its fundamentals, and if it is truly undervalued, how good are the chances for the price to go up? What Wall Street labels as a value stock is, in reality, a stock that, at a certain point in time, is selling at a bargain price... a very temporary thing. Once the stock goes up in price, the "value stock" label disappears.

Growth stocks, on the other hand, are most often thought of as flashy startups, high tech innovators, and generally more speculative entities that should be dealt with carefully. These are the bread and butter of both growth and index funds and are the kind that the media covers most extensively. Popular definitions describe growth stocks as those of companies that:

  • Are growing earnings and/or revenue faster than their industry or the overall market.
  • Pay little or no dividend, preferring to use their income to finance expansion.
  • Are young, with little or no earnings history, and are valued on the basis of anticipated future earnings.
  • Have high price-earnings ratios.
  • Are currently growing earnings with potential to continue growing earnings 15% to 30% annually for the next one to three years.

To summarize, these labels are purposely flexible concepts that attempt to compare current equity prices either with past accomplishments or with future potential. So a "value" or "growth" label can be applied to a particular stock by almost anyone who owns a calculator and who thinks they have the ability to predict the future. The result is that some people will label a given stock one way, while others will label it entirely differently.

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