Usually, there are two broad fundamental ways to invest in stocks—value and growth. Growth investors look for companies that offer strong earnings growth. Value investors seek out companies whose stocks appear to be undervalued. Looking at value versus growth stocks, which is better?
During the reset that happened at the beginning of 2021, many high-flying growth stocks fell hard (and value stocks rose). Higher inflation expectations gave rise to higher interest rate expectations. This led to a broad rotation from growth to value stocks and after many years value investing came back in vogue.
Characteristics of growth and value stocks
Growth companies may or may not have a history of depicting higher-than-average earnings growth. However, the outlook for their earnings growth is usually strong. Since these stocks have the potential to outperform the market’s growth rate, investors are willing to pay a higher price for them, which might jack up their valuations to a very high level. A lot of future expectations are already priced into their stocks. Therefore, a slight disappointment might cause them to correct sharply.
Investing opportunities in value stocks might arise for many reasons. Either the market hasn't realized their full potential or the stocks might have sold off due to a negative short-term event. Such timing provides an opportunity to buy them cheaper and benefit from stock price appreciation as the short-term anomaly gets corrected. In an efficient market, it's assumed that over the long term, the stock value will rise or fall to trade in line with its intrinsic value.
Investors need to be careful while selecting value stocks. The stock values might have declined not because they're being mispriced but because there's a genuine reason for concern.
Value versus growth stocks in different interest rate scenarios
The economic cycles impact growth and value stocks differently. In general, value stocks do well when interest rates are rising or are expected to rise. The cash flows of many growth stocks are expected to come in the future. When the discount rate (interest rates) rises, the value of those cash flows discounted to today’s price lessens. Therefore, higher interest rates lead to lower valuation for growth stocks. Value stocks are impacted less by a said increase in interest rates.
Examples of value stocks versus growth stocks
Growth stocks could come from any sector but currently, technology-related names are depicting strong growth potential. The names in this space include Apple, Tesla, NIO, Amazon, Snowflake, Nvidia, and Square.
Growth or value stocks?
Usually, for a seasoned investor, the two investment styles complement each other. Over the long term and throughout economic cycles, a combination of growth and value might provide one of the best returns. Therefore, it makes sense for investors to have both stocks in their portfolios to derive diversification benefits.