Growth and value investing are two fundamental approaches to building a stock portfolio. Growth investors seek companies with solid revenue or earnings growth, whereas value investors prefer undervalued stocks. While asset managers may specialize in one or the other, most investors take a blended approach and include both in their portfolios.
Let’s take a look at the differences between growth and value investing and how you can choose the best option.
What is Growth Investing?
Growth investors seek fast-growing companies for their portfolios. In particular, they may look for rapidly growing revenue, earnings, or more nuanced metrics like customers or contracts growth. Since growth is the priority, these companies reinvest profits into their businesses and don’t typically offer dividends or focus on shareholder returns.
Many growth investors use a top-down approach by looking for the fastest-growing industries or countries, like technology or emerging markets, and then seeking out companies beating expectations in these areas. Others may seek out entirely new sectors, like cryptocurrencies, and seek out companies in these areas.
Some growth investing metrics include:
- TTM Sales Growth – Companies with growing sales over the past 12 months.
- Long-term Sales CAGR – Companies with durable sales growth that’s not short-term.
- Gross Profit to Asset Ratio – Companies that are using their assets well to grow revenue.
Cathy Woods is an excellent example of a growth investor. Through her thematic ARK ETFs, she invests in fast-growing companies capitalizing on emerging market trends. In 2020, these funds soared an average of 150% as the COVID-19 pandemic accelerated the adoption of new cutting-edge technologies, such as video conferencing. Sadly, those that jumped on the ARK bandwagon aren’t faring so well. Her funds have seen steep declines in 2022.
What is Value Investing?
Value investors seek diamonds in the rough for their portfolios. In particular, they look for companies with stock prices that don’t reflect their fundamental value. Then, over time, value investors assume that the market will eventually recognize the value, and the stock price will increase. Value companies tend to be older firms in more stable industries. In many cases, investors have lost interest because they are no longer in the hot, new thing. As value investors wait for the market to recognize their true price, these companies may offer an attractive dividend.
Many value investors take a bottom-up approach by screening for opportunities using price-earnings or price-book ratios. After creating a shortlist, they may then use discounted cash flow analysis to determine a fair value and look at book value to determine the margin of safety. The best opportunities are so undervalued that they have little room to fall further.
Some value investing metrics include:
- Price to Free Cash Flow – How much you’re paying per dollar of free cash flow.
- Enterprise Value to EBITDA – How much you’re paying per dollar of EBITDA.
- Price to Book – How many assets support the stock price.
Warren Buffett is the quintessential value investor. Between 1965 and 2020, his Berkshire Hathaway vehicle realized a 20% compounded annual gain compared to just 10.2% for the S&P 500 index. While Berkshire is too large to pursue many value-investing opportunities today, the business leverages its scale to make attractive acquisitions.
Impact of Market Cycles
Most investors are familiar with market cycles, but few realize the trade-off between value and growth stocks. For example, Ben Carlson, CFA, points out that the Russell 1000 Growth and Value Indexes have nearly identical annual returns from their inception in 1979 and March 2021, but they took a very different route to get there.
Source: Returns 2.0
Growth stocks tend to outperform during bull markets, while value stocks outperform during bear markets. After all, investors are unwilling to pay as high of a multiple on growth stocks if they expect growth to slow down. Meanwhile, value stocks may become more attractive since they already trade at low multiples and have less room to fall.
Of course, the challenge is determining when market cycles will shift. Schwab research shows that the cost of waiting for the perfect moment to invest typically exceeds the benefit of even perfect market timing. That said, you can adjust your allocations to value and growth when the market feels high or low while remaining fully invested in stocks.
Blending Value & Growth
Blended funds invest in growth and value stocks using a strategy known as “growth at a reasonable price” or GARP. In essence, they seek out growth stocks but analyze them using value metrics. The result is exposure to fast-growing opportunities but more downside protection if the market turns south and valuations decrease.
For example, the Invesco S&P 500 GARP ETF (SPGP) invests in S&P 500 index securities, but rather than weighting them by market capitalization, the fund managers look at “growth scores” and “quality and value composite scores” to weigh them. These scores look at financial leverage, return on equity, and price-earnings ratios.
Covered calls provide another way to blend value and growth. For example, when holding a growth-focused portfolio of stocks, investors could sell covered calls to generate an income that reduces their cost basis over time. The strategy is especially beneficial for retirement investors that want to create an income to support their spending requirements.
OptionDash is one of the easiest ways to find covered call opportunities. Using advanced screening criteria, you can choose from a long list of fundamental data and ratios while looking across various expirations or moneyness. You can also keep track of your favorite opportunities using watchlists and instantly access quality, value, and trend scores. Try it for free!
The Bottom Line
Growth and value investing are two different fundamental approaches to building a portfolio. While most investors blend both strategies, they may adjust their allocations to each strategy based on market conditions. Growth stocks tend to outperform during bull markets, whereas value stocks do better during bear markets.
If you’re interested in covered calls as a way to blend value and growth, the Snider Investment Method provides a helpful framework for finding the best underlying stocks and call options. The methodology also helps you decide what strike prices and expiration dates to maximize income—a valuable tool for retirement investors.
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