What's a growth stock? A value stock? Equity market style explained

June 13, 2018

In addition to size as measured by market capitalization, stocks are often categorized as either growth or value. To a novice investor seeking to build a diversified equity portfolio, the notion that the broad market can be divided into these two styles might beg the question, “Growth and value are both good qualities, so why wouldn’t I want to invest in both types of stocks?”

What's a growth stock? What's a value stock? Equity market style explained

That inclination is on target. Broadly speaking, equity investors should have sizable allocations to both styles of stocks, apportioned to match their investing time horizons and risk tolerance. But what are the differences between growth and value, what implications do they have for portfolio construction, and what indicators in today’s market might offer clues about the relative performance of each style going forward? 

Growth and value defined

A useful starting point might be to think of growth and value stocks as fruits and vegetables, or as protein and carbohydrates. You need nutrients from each group to maintain a balanced diet, and leaving out one altogether could put your health at risk.

Growth stocks are generally regarded as those that seek to generate revenue and earnings at an above-average rate—for example, think of today’s fastest-growing information technology names or biotechnology stocks with promising drug pipelines. Owing to such strong growth potential, investors are typically willing to pay a premium for these stocks, as reflected by stock prices relative to the earnings or net assets of the underlying companies.

As for value stocks, earnings are generally steadier and slower-growing than those of growth stocks, often reflecting the relatively long history of their business models and revenue sources. Rather than spending down most of their cash reserves to expand, value stocks are more likely than growth stocks to pay dividends. They're also considered relatively inexpensive based on metrics such as price-to-earnings or price-to-book ratios. Examples of companies that typically are categorized as value stocks are energy utilities and makers of consumer staples such as food and household goods.  

Not mutually exclusive

Not all stocks possess characteristics that place them exclusively in either the growth or value bucket. Firms that design market indexes may include a given stock in both a growth index and a value index if the stock has characteristics that could qualify it for either bucket. For example, the Russell 1000 Growth Index and the Russell 1000 Value Index are both subsets of the Russell 1000 Index, which is made up of the 1,000 largest publicly traded U.S. stocks ranked by market capitalization. Yet there’s not a 500/500 split in the growth and value segments of the broader index; the Russell 1000 Growth Index had 550 stocks as of April 30, 2018, while the Russell 1000 Value Index had 710.1 Some stocks were components of both indexes, because they had characteristics that qualified them for overlapping membership.

Measuring growth versus value

The Russell indexes use a single value characteristic and two growth characteristics to categorize stocks by style:

  1. Value as determined by price-to-book ratio, or the ratio of a stock’s price to its book value per share (book value is an accounting term reflecting the net value of a company’s assets and liabilities.)
  2. Growth as determined by a two-year forecast for the company’s earnings growth rate
  3. Growth as determined by sales per share over the past five years1

In numeric terms, the differences between growth and value stocks are significant. For example, the price-to-book ratio for the Russell 1000 Growth Index as a whole was 6.58 as of April 30, 2018, versus a lower-priced 2.04 for the Russell 1000 Value Index. As for dividends, the value index was a bigger source of potential equity income, with a dividend yield of 2.50%, versus 1.36% for the growth index. As for earnings growth, the growth index had projected earnings-per-share growth of 13.43% over 5 years, versus 4.01% for the value index.1

These differences are reflected in the sector representation within each index. Information technology has by far the greatest representation in the growth index; each of the top five stocks in the index, as ranked by market capitalization as of April 30, was a tech name: Apple, Microsoft,  Amazon.com, Facebook, and Alphabet, the parent company of Google. In the value index, the top five sectors, in order, were financial services, healthcare, energy, utilities, and information technology. 

Investment implications

For many investors, portfolio allocation decisions are driven by the risk level associated with the potential return of a given investment. In this regard, growth and value stocks can differ significantly. Using standard deviation, a common volatility metric that measures performance fluctuation, the Morningstar U.S. Growth Index had a 16.39 figure for the 10-year period ended May 30, 2018, versus 13.66 for the Morningstar U.S. Value Index.2 The higher a stock index's standard deviation, the more volatile its performance has been. As a result, an equity portfolio with greater exposure to growth stocks relative to their value counterparts was likely to have been more volatile than a portfolio with a greater weighting in value stocks. Growth stocks’ higher prices relative to earnings come with a cost: If a growth stock fails to deliver on the market’s relatively high expectations for its earnings potential, the stock could significantly underperform. With lower expectations, value stocks are likely to offer a somewhat steadier ride.

However, growth stocks have generated significantly stronger overall performance over the 10-year period ended June 11, 2018. The Russell 1000 Growth Index had a total return of 11.7%, versus 8.2% for the Russell 1000 Value Index.1

Which style looks better today?

Historically, performance leadership has shifted between growth and value, and in several instances one style has maintained an edge for several years before the situation reversed. We are now in one such period, as the Russell 1000 Growth Index has outperformed its value counterpart in 7 of the past 11 years. In 2017, growth’s outperformance was unusually strong, as the Russell 1000 Growth Index returned 30.2%, versus 13.7% for the Russell 1000 Value Index. Growth’s leadership extended into early 2018, as the growth index posted a 9.7% total return through June 11, versus 0.6% for its value counterpart.1

Growth and value stock performance can vary widely over annual and multiyear periods

However, growth’s outperformance in recent years followed a long stretch of leadership for value, which outperformed for seven years in a row. That run started in 2000, as the tech bubble that had inflated the prices of many growth stocks began to burst; it ended in 2007, prior to the financial crisis that began in 2008.   

Whether leadership will return to value stocks in the near term or not, investment strategies that overweight value stocks remain popular, as exemplified by the emergence in recent years of smart beta strategies that track custom-designed indexes weighted in favor of certain characteristics. Many of these strategies are weighted to favor value characteristics, owing in part to a wide body of academic research showing that value stocks have outperformed their growth counterparts over long periods of time. Among these is a landmark 1992 study by University of Chicago Professor Eugene Fama and Dartmouth College Professor Kenneth French, who argued that, based on history, focusing stocks with value characteristics such as lower relative prices may improve a portfolio’s expected return.3

In any case, it’s worth remembering that any extended run of outperformance for a certain segment of the market, such as growth stocks, is likely to revert to underperformance at some point. Just as it makes sense to eat a balanced diet, most investors will be well served to allocate broadly across the growth and value segments of the market to maintain a diversified equity portfolio.

 

1 FTSE Russell, June 2018.

2 Morningstar, Inc., June 2018.

3 “The Cross-Section of Expected Stock Returns,” Eugene F. Fama, Kenneth R. French, Journal of Finance, June 1992.