Growth companies are usually newer, more technologically driven, up-and-coming businesses with sky-high investor expectations. They are usually considered the industry disruptors that may or may not continue to innovate and expand. This can make investing in these companies more speculative in nature, because a lot of today’s success is to be determined by tomorrow’s earnings.
Value companies, on the other hand, tend to be more mature companies that may be undervalued based on their proven long-term profitability and strong foothold in their industry. Though stock price appreciation is never guaranteed, there’s a general consensus that value companies are usually more appropriately priced in the market due to their less-speculative nature and stronger current cash flow.
We can see these stock price discrepancies when we examine the fundamental valuation metric known as the price-to-earnings (P/E) ratio. The P/E ratio, also sometimes referred to as the price multiple or the earnings multiple, measures a company’s current share price relative to its per-share earnings. In layman’s terms, this is the dollar amount an investor can expect to pay for a company today in order to receive one dollar of that company’s earnings in the future.
With this in mind, and to provide an example to help illustrate the differences between value and growth stocks, let’s turn to a pair of actual funds designed to track the indexes we’ve been discussing, the iShares Russell 1000 Growth ETF and the iShares Russell 1000 Value ETF. The weighted average P/E ratio of these two respective investment strategies is 17.5 for the value fund and 28.4 for the growth fund.(1) Clearly, on average, stocks in the growth fund are much more highly valued than stocks in the value fund. To examine an extraordinary example at the company level, look no further than the fifth biggest holding in each investment strategy. Tesla currently trades at an astronomical P/E ratio of 1,000 whereas Bank of America trades much closer to Earth at 19.8.(1)
There is another important distinction to make note of, and this discrepancy comes at the hands of the percentage of assets in the top 10 holdings of each strategy. The value fund has 16.6% of its assets in 10 companies while the growth fund has fully 44.2% of its assets in 10 companies.1 What this means is that the value strategy is significantly more diversified than the growth strategy. As a result, value-oriented investment strategies can be less susceptible to concentration risk, which is the risk of amplified losses that may occur from having a large portion of holdings in a particular investment, asset class or market segment relative to the overall portfolio.
Given how loosely the terms “value” and “growth” are thrown around in the financial news today, it’s easy to see how their constituents can be easily misconstrued. But understanding these distinctions can be valuable, empowering you to focus on the long term while blocking out short-term performance noise and ultimately to stay comfortably committed to an evidence-based investment strategy.
Going forward, when thinking about the benefits of value-oriented strategies, consider these three primary takeaways:
- They tend to have healthier valuations, as indicated by lower P/E ratios.
- They tend to be more diversified, as indicated by lower portfolio concentration.
- They tend to have stronger company fundamentals by virtue of incorporating more mature businesses.
Oscar Wilde is credited with saying, “The cynic knows the price of everything and the value of nothing.” This wisdom may be more applicable than ever when it comes to the constant rhetoric surrounding growth and value companies.