Question: I see a lot of articles about value vs. growth and which stock will do better over time, but I’m not sure what that means. What should an average investor know about value and growth?
Answer: This is a confusing topic because there are many definitions and they are used loosely and interchangeably. Here are a few examples of what value and growth mean to different people:
Professors Eugene Fama and Kenneth French did research into factors that drive investment returns. Dividing the overall market value of a company by the value of assets they own creates a metric called the “price-to-book” (p/b) ratio. This is one way of considering whether a company is cheap or expensive. Famously, the Fama-French research found that cheap stocks (low p/b) tend to outperform expensive stocks (high p/b). They called the cheap stocks “value” and the expensive stocks “growth.” It’s unfortunate that they decided to use these terms because “growth” sounds much more alluring than “expensive,” which is what the authors really meant by growth in this context.
There’s a category of active investment managers known as value investors, and they don’t give a darn how a couple of finance professors define value and growth. Value investors simply like to try to buy a dollar for less than a dollar by finding undervalued, underpriced, misunderstood opportunities. Their picks might often have a low p/b ratio but just as easily might not. For example, Alphabet (Google) is a position widely held by value investors today. They likely choose it not because it is cheap by traditional valuation metrics, but rather because they believe there are aspects of the company the market doesn’t fully understand or appreciate. A value investor could easily buy an “expensive” stock like Google if their calculations suggest it’s worth more than its market price today. Note that expensive and cheap have nothing to do with the share price. In this context, it doesn’t matter if the share price is $5 or $5,000.
A more informal definition of value vs. growth has to do with earnings. Companies that are growing quickly might not pay a dividend today, but the promise of big future dividends or an eventual payout due to the company being acquired is enough to draw investors in. These are often referred to as growth companies. Mature companies that are not growing quickly attract investors through things like dividends, share buybacks, and mergers and are considered value companies. This is probably the least clearly defined facet of value vs. growth, and is probably best summarized as young companies (growth) vs. mature companies (value). There’s no widely accepted definition here, but most people know it when they see it.
To further confuse things, there is the matter of mutual fund regulation. Each fund is required to state a prospectus objective. A pure bond fund with the goal of generating investment income from bond coupons is likely to have an income objective. A stock fund targeting share price appreciation with little or no dividend yield tends to state growth as an objective. Funds targeting a mix of the two often declare they are “growth and income” funds. Here, growth means “stuff we hope will increase in price over time,” or just stock exposure. It has nothing to do with the specific qualities of the companies being purchased.
When an average person chooses funds in a 401k, they probably aren’t applying any of these definitions. Sadly, it can end up being like a Rorschach test — does value or growth define you as a person? (Side note: Don’t pick funds like this!)
There’s a deep desire in our reductionist culture to simplify complex concepts into single numbers or labels, which is the reason why the investment community has tried to cram a wide variety of concepts into these two simple terms. There’s no simple answer that will always work perfectly in every market environment; otherwise, everyone would be doing it and we wouldn’t be having this conversation.
Whether you choose your own investments or use an advisor, always make investment decisions deliberately and with full understanding of how investments are picked by the fund manager and why. A mistake compounded over time can have profound negative implications, just as good choices can pave the long-term path to a secure financial future, whether those choices are labeled value, growth, or something else entirely.
Gene Gard is Co-Chief-Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions.
