Growth vs. Value?
One of the longest-running dichotomies in investing is the ongoing tug of war between growth stocks and value stocks. Growth stocks are generally seen as companies that are growing consistently and, typically, at above average rates. Value stocks, on the other hand, are companies whose progress is less consistent and often relatively slow.
At first glance, one wonders why investors would look beyond growth stocks to fill out their portfolios, but there’s more to the task of portfolio construction than just picking market stars such as Amazon, Apple, Facebook, and the like.
Here’s the hitch. Over time, most growth stocks will turn in better returns than most value stocks. The key word here is most. A portfolio of diversified growth stocks will usually be selling at significantly higher valuations (price-earnings ratios) than a portfolio of diversified value stocks. Why? Because more rapid and more consistent growth rates give investors greater confidence that these patterns will continue. That confidence is the reason why they will pay more.
The problem is the tendency of growth stock valuations to get stretched beyond reasonable levels. In Wall Street parlance, that situation is referred to as “priced for perfection”. These rich valuations lead to the risk of major, rapid price plunges if there are earnings shortfalls or other negative business developments within companies. In these cases, the impact of even one such drop will markedly bring down the average performance of the entire portfolio.
Value stocks demonstrate the flip side of this equation. In reflection of their relatively mediocre financial and market performances, their valuations tend to be quite lean. Investors don’t expect much from them and exhibit that expectation by buying only when they are relatively cheap. When earnings are weak or there’s disappointing news, not much happens . . . unlike the case with growth stocks.
Yet every now and then these companies announce results that are well above what had been expected and their shares rise dramatically. Not surprisingly, when this happens in a diversified portfolio of value stocks, the average performance jumps, often beyond that of growth stock portfolios.
In many ways, this is a mirror image of what’s known as the Dogs of the Dow Theory, which is based upon annual portfolio rebalancing and concentration on the highest yielding stocks in the Dow Jones Industrial Average. It’s also akin to the popular high dividend yield approach (using a broader universe than the Dow).
The common denominator for all of these is the importance of having a broadly diversified portfolio to increase the opportunity for positive surprises and limit the exposure to downside disappointments.
N. Russell Wayne, CFP®
Sound Asset Management Inc.
Weston, CT 06883
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