If you are thinking of getting into the stock market, it is essential to find out what stocks are right for you. For one, you will want to consider whether you should invest in value stocks or growth stocks.
Growth stocks are stocks that have the potential to outperform the market over time while value stocks are stocks that are trading below what they are really worth, so they are likely to provide a good return.
But which one is better? This article will take a look at the pros and cons of both so you can make a decision that’s right for you.
Growth stocks are considered to be undervalued. Therefore, they have the potential to outperform the overall market or a subsegment of the market for a period of time.
Growth stocks can be found in small, mid and large cap sectors, meaning they are issued by large corporations with various market capitalization rates. They will stay classified in their sector until they have reached their potential.
The companies that issue them are considered to have a good chance of expanding over the years due to the product lines they are releasing or trends that predict they are expected to outrun their competitors.
Value stocks are issued by larger, well established companies that are trading below the price analysts think the stock is worth based on the financial ratio or benchmark it’s being compared to. So, for example, if the book value of the company’s stock is $25 a share, and it’s currently trading at $20 a share, this would be considered a good value stock investment.
There are many reasons why stocks may be undervalued. Sometimes an internal scandal or a product recall can push the value down.
However, if the company has a reputation for being financially stable, those interested in cashing in may see this as a good opportunity to get on the ground floor. They will realize that the scandal will eventually blow over and the price of the stock will rise so they can profit.
Some stocks can be classified as both value and growth stocks. This occurs when the stock is considered to be undervalued and also has the potential to increase. These stocks may be placed in a blended category.
Which Stock is Best for Me?
With both value and growth stocks, there is always the possibility that they will not perform as expected. Therefore, there is some amount of volatility and risk involved.
In general, value stocks are considered to have a lower risk because they are usually issued by larger companies who have more stable financial histories. And even if they don’t get to their target price, they can still offer capital growth and pay out dividends.
Growth stocks, on the other hand, are less likely to pay out dividends. Instead, the retained earnings are usually reinvested into the company to allow for expansion. Investors may also lose money if the company is unable to keep up with growth expectations.
For instance, if the potential for growth is based on a new product, and that product turns out to be unsuccessful, investors could end up losing money. In general, growth stocks can yield greater returns than value stocks, but they also come with a higher risk.
It may be difficult for investors to determine which stock is best for them based on the information given so far, so let’s take a look at some studies that provide information on how each performed historically.
The first study was conducted by research analyst John Dowdee. Dowdee published a report on the Seeking Alpha web site where he broke down stocks into categories based on the risks and returns for growth and value stocks in small, mid-sized and large cap sectors.
The study looked at the time frame from July 2000 to 2013 and found that value stocks outperformed growth stocks on a risk adjusted basis for all three sectors even though they were more volatile than the growth stocks being reviewed.
However, when broken down into shorter periods of time, the growth stocks came out ahead.
When the study reviewed the years 2007 to 2013 only, the growth stock yielded higher returns in each sector. Therefore, the study offered no conclusive evidence other than that the success of the stock may be contingent on time period over which it is was held.
A second study was conducted by Craig Israelson who published his results in Financial Planning magazine in 2015. Israelson took a look at growth and value stocks in all three sectors over a 25-year period spanning 1990 to 2015.
The results of the study showed the large cap value stocks yielded a higher annual average return than large cap growth stocks beating it out by about three quarters of a percent. The difference was even greater for the small and medium sectors with value stocks coming out ahead every time.
However, the study also showed that over every five-year period within the study, large cap growth and value stocks were almost evenly split in terms of returns. Small cap value stocks beat out growth about three quarters of the time, but when growth came out ahead, it did so by a much larger lead.
It is worthwhile to note that small cap value beat out small cap growth almost 90% of the time over rolling 10-year periods and mid cap value also beat out growth.
With both stocks showing the potential to yield high returns over time, an investor should make a decision based on risk tolerance, investment goals and the time they are looking to invest for. It’s also wise to look at market trends as this will affect a stock’s performance.
It is worth noting that value stocks tend to do well during bear markets and recessions while growth stocks thrive during bull markets and times of economic expansion.
Growth or value? Which will you choose when it comes time to invest?