Value vs Growth Investing : Which Is The Better Approach (2024)

When it comes to making investments, investors can choose between various options – Active vs. Passive, Debt vs. Equity, Mutual Funds vs. Stocks, and Growth Investing vs. Value Investing. Growth and Value investment styles are among the most commonly used investment strategies, and there are significant differences between the two.

The growth investment strategy focuses on identifying companies that can substantially grow their revenues and profits compared to their competitors. So, growth stocks have the potential to witness a sharp rise in stock prices within a short time.

On the other hand, value investing is a slower and steadier investment approach. Value investing focuses on identifying and investing in companies whose stock prices are lower than their intrinsic value. This strategy focuses on making investments in undervalued stocks that can deliver high returns when the stock prices move closer to their intrinsic value.

In this blog, we will take a closer look at these two distinctive strategies based on the differences in their objectives, valuation metrics, and performance. Knowing these differences can help investors identify which strategy is better suited to their investment goals.

Differences in Investment Style between Growth and Value Investing

Growth investment strategy identifies companies whose earnings per share (EPS) or earnings before income tax and depreciation (EBITDA) are growing higher than their industry peers. The critical assumption is that this above-average performance of growth stocks will continue in the future. Companies showing such outperformance might be new or belong to an emerging sector that can become an industry leader in the future.

The key risk of investing in growth stocks is the potential volatility in stock performance, especially in the short term. What’s more, in many cases, growth stocks might be relatively recent market entrants with short or no historical trends that support the premise of future growth.

To understand this better, let’s consider the example of Zomato, which recently completed its Initial Public Offering (IPO). The below table shows the annual sales, growth, net profit, and dividend payout information of Zomato for the FY2016 to FY2021 period:

The Zomato data shows that even though sales have increased, the company has not made a profit. What’s more, the company has not paid any dividends to its shareholders during the past 6 years either.

But, an investor following the growth strategy would instead focus on the potential of Zomato to become a more prominent player in the food delivery sector in the future and become highly profitable.

But, various factors can play a vital role in a company’s growth. For example, stock growth may be driven by acquisitions made by a company or external factors that provide tail-wind to the sector and promote growth. The impact of external factors is clear from the example of HEG Limited, a leading player in India’s graphite electrode industry. In FY2018 and FY2019, the price of graphite electrodes increased sharply and reached levels of 8 to 9 times the previous year globally. As a result of this external factor, HEG Limited witnessed a sharp increase in sales and profits, as shown below:

However, as you can see, while the higher global prices of graphite electrodes enabled HEG Limited to post record sales and profits in FY2018 and FY2019, this increase in profitability was short-lived. This is why investors need to consider additional factors such as industrial cycles when identifying growth companies to invest in.

Value investing strategy takes a very different approach when selecting investments. Instead of focusing on companies posting recording-breaking numbers, value investors pick stocks of established companies that belong to mature sectors and have more predictable revenues.

Value investing is thus involves hunting for bargains by identifying stocks that are priced at a significant discount compared to the intrinsic value of the stock. So while value investing focuses on the current price of a stock for making the selection, growth strategy focuses more on the future direction of the company’s business.

Valuation Considerations in Growth Investing vs. Value Investing

As mentioned in the earlier section, a value investor needs to consider the intrinsic value when making the stock selection. One of the most commonly used stock valuation techniques value investors use is theprice-to-earnings ratio or P/E ratioof the stock. The formula to calculate the P/E Ratio of a stock is this:

P/E Ratio = Share Price/Earnings per share

So, the P/E Ratio can help investors determine the investment required for each rupee of profit that the company makes. Now, growth stocks often have low profits when selected for investment, but there is an anticipation of higher future profits. So, the P/E Ratio of growth stocks tends to be higher than the P/E Ratio of value stocks.

But P/E Ratio is not the only metric that is used for the valuation of stocks. The below table shows other commonly used valuation metrics and how these metrics differ between growth and value investing strategies:

So, growth stocks typically have a higher price than value stocks compared to their profits, book value, or operational cashflows. On the other hand, value stocks usually offer higher dividend payouts and dividend yields than growth stocks.

So, growth stocks are more expensive and can have significantly high P/E and P/B Ratios driven by the future growth potential of the stock. This can turn out to be a very profitable investment, like in the case of Apple Inc.

In December 2007, Apple Inc stock was $6, and it had a substantially high P/E ratio of 40 compared to the industry average of 18. While this would have made the stock seem expensive to a value investor, a growth investor would have focused on the future direction of the company and its revolutionary product – the iPhone.

Since then, the company’s performance has been stellar, and an investor who bought Apple Inc. shares in December 2007 would have received annualized returns of 25% on the investment during the past 14 years. This is how growth investing works – a stock that seems to be expensive now but may turn out to be a bargain if the company grows successfully in the future.

Performance Comparison – Growth Stocks vs. Value Stocks

The performance of growth stocks and value stocks has been extensively debated by experts favoring either of these investment strategies. But quite often, the performance of value stocks and growth stocks are cyclical in nature. This periodic outperformance by each type of stock is clearly observed if you compare the annualized returns of the US-based Russell 1000 Growth Index and the Russell 1000 Value Index over different time periods:

So, you see, during 1989-1999 and also 2009-2020 periods, the Russell 1000 Growth Index clocked annualized returns of over 20%. In contrast, the Russell 1000 Value Index outperformed the growth index during 1979-1988 and also between 2000-2008. This indicates that the preference for value investments and growth investments changes every 10 years or so.

To get a clearer picture, let’s consider the data of the same indices over shorter periods based on 3-year rolling returns of the indices:

From the above chart, you can see that growth and value stocks have taken turns outperforming one another even in the short term. Moreover, this cycle of change seems to be driven by turbulent conditions in the stock markets following crucial events such as Black Monday (1987), Dotcom Bubble (2000-01), Global Financial Crisis (2008), etc.

ETMONEY Opinion

Both growth and value investing offer a unique set of opportunities, objectives, measurements, and drawbacks to investors, as summarized in the below table:

Based on the above considerations, investors can choose between 3 possible options:

Option 1:Pick either growth or value style and stick with it

Option 2:Try and pick the strategy that will outperform at a given time

Option 3:Buy a few growth stocks as well as a few value stocks

However, neither of these options is perfect, and investors need to consider a few factors when selecting one of these options. For example, if one picks either growth orvalue investingand sticks to it, the investments will outperform and underperform periodically depending on changing market conditions. What’s more, you can never anticipate how long each of the boom and bust cycles will last.

If an investor selects option 2, success will depend primarily on the investor’s ability to time markets correctly every time, which is near impossible. Taking the third option would mean always staying invested in a few underperforming stocks that can impact overall portfolio returns.

Due to the limitations of pure value and pure growth strategies, many inventors are now favoring the use of hybrid strategies that incorporate the best features of both strategies. One such hybrid strategy that has become popular recently is Growth at a Reasonable Price or GARP. The objective of GARP is to provide a stock selection criteria that strikes a balance between the growth and valuation strategies. Using GARP, investors can pick and choose stocks with strong fundamentals that are reasonably priced. Such investments can turn out to be quite lucrative and yield high returns within just a few years.

While developing and using a hybrid strategy might look simple in theory, it might be quite difficult to implement in practice. As a result, seasoned investors often say that good investments require 3 key ingredients – a bit of luck, a fair amount of skill, and a lot of discipline.