Growth or value stocks? Yes.


Justin Burgin, Vice President, Equities Research – Ameriprise Financial

Person holding phone showing stock market performance on the screen

A longstanding debate among investors is whether to invest in stocks from growth or value companies. 

As with any good argument, each camp has ardent followers, a bevy of data to support their thesis and unbridled predictions about future performance. There is also a healthy dose of recency bias — more importance placed on recent trends — to justify the views and portfolio allocations.

So, who is right? We believe the answer is somewhere in the middle.

 

At a basic level, how are growth and value defined? 

Growth companies emphasize revenue growth, gains in market share and reinvestment into the business (versus paying dividends or buying back stock). They often operate in new or disruptive segments of their respected industries and sectors. 

As a result, key valuation metrics such as price-to-earnings (P/E) and price-to-sales (P/S) among growth companies are often well above broad market averages. However, their stock prices also experience greater volatility over time. 

Value companies, in contrast, are typically larger firms generating more modest revenue and earnings growth in more established industries. These companies often pay dividends and use share buybacks to enhance shareholders’ total return (i.e., returns beyond the price appreciation of the stock). 

Because value companies have lower growth profiles, their valuation metrics are often below market averages. The table below helps demonstrate the disparity between value and growth metrics.

Table outlining value and growth metrics

This example is shown for illustrative purposes only and is not guaranteed.

Trailing price/earnings, price/book, and price/sales are all based on trailing 12-month data.  Forward price/earnings are consensus estimates for the next 12 months.

 

How growth and value characteristics can blend

It is no secret that growth companies are often technology and biotech firms that create new markets or redefine existing ones. However, many mature sectors of the market, such as the Industrials and Financials sectors, have growth companies among a more extensive grouping of value firms.

For example, Industrials sector growth companies may address new markets such as space exploration, autonomous driving and electric vehicles. Conversely, the value-heavy Financials sector may include growth companies participating in markets such as data analytics and venture capital.           

 

Interest rates and far out cash flows

The current and expected level of interest rates is an overlooked factor that impacts the growth vs. value debate. Why do interest rates matter? 

The price of a stock should, at some level, reflect the future stream of all cash flows from the company, discounted back to the present. As such, using a higher interest rate to discount future cash flows would mean a lower net present value, while the opposite holds true for a lower discount rate.

With all else remaining equal, higher interest rates are generally considered a headwind for stocks. However, for many growth companies the bulk of cash flows are expected to be realized five, 10 or 15 years in the future, while value companies may already be generating healthy cash flow due to their more mature industries. Think of a relatively new electric car company (growth) versus a global snack and soda provider (value).

In a rising rate environment such as September 2020 through May 2021 — when the 10-year Treasury moved to 1.6% from 0.5% — the impact on growth versus value was evident, as illustrated in the following chart. 

S&P 500 value vs. growth line chart

 

As interest rates rise (which equates to a higher discount rate for future cash flows), growth stocks can be disproportionately impacted compared to their value counterparts. To highlight the importance of rising interest rates on stock valuations, famed investor Warren Buffet said, “interest rates basically are to the value of assets what gravity is to matter.”

We think investors on both sides of the growth vs. value argument can pinpoint a relatively short time period that helps support their positioning. The following three charts are good examples. 

 

Growth outperforms value (March 23, 2020–Aug. 31, 2020)

S&P 500 value vs. growth line graph

 

Value outperforms growth (Sept. 1, 2020–May 30, 2021)

S&P 500 value vs. growth line graph

 

Near-identical performance between growth and value (May 31, 2020–May 31, 2021)

S&P 500 value vs. growth line graph

These examples are for illustration purposes only and are not meant to represent any specific investment or imply any guaranteed rate of return. Past performance is not a guarantee of future results.

 

Those three examples help highlight our view that a long-term, diversified portfolio includes stocks from value and growth companies to support your financial goals, help reduce risk and smooth out short-term market volatility. So, the next time you’re asked whether you favor growth or value stocks in your portfolio, a smart and diversified answer would be… yes!