The ultimate question, value vs. growth stocks. Which is suitable for my portfolio? Which is a better performer? How do they differ, and what is the easiest way to buy them?
There are differing schools of thought on this, as with everything in investing. There are hardcore value folks who will only buy stocks that sell at a discount. Then there are growth fanatics who will show you Tesla’s stock chart, forgetting the fact that despite its impressive growth, Tesla didn’t make any money for years and nearly went bankrupt many times. A typical sight with growth stocks. On the other hand, “value traps” are also common. Price does not equal value, and high growth potential doesn’t mean the stock price is justified. So what should we do?
Value Stocks vs. Growth Stocks. Key differences
What exactly is “value”? There are two different definitions that we must understand. Typically value stock refers to company stock that trades at a low multiple. The most popular multiple people talk about is the P/E ratio or price of a stock on the market right now to earnings per share that a company earns. Other ratios include Price to Book, Price to Enterprise Value, and so on. The point is, you look at the price and compare it with other companies using a metric of your choice. Companies with the lowest price are added to the list.
Can you spot a problem with this logic? What if the company’s low price is justified? This is where the art of value investing comes in. To truly understand if the stock is a value stock, you must understand the business well enough to figure out if it’s worth more than it is selling for.
ETFs that attempt to replicate this strategy avoid the problem by looking at larger-capitalization companies. The logic goes, if the company is well established but sells at a discount (lower than market P/E ratio, for example), it is a “value” stock. This only mitigates part of the problem, however. The easiest way to replicate something like that would be to take S&P 500 for example and just buy stocks that have a P/E ratio of below some arbitrary number.
Here is an example of the top holdings of VTV – Vanguard’s Value ETF.
The problem is that the price you pay is crucial in determining whether something is of value. Just buying Berkshire Hathaway or Proctor & Gamble at any price does not make you a value investor. The value of any investment is a function of price. Companies’ earnings are finite, and therefore, there is a very real ceiling of how far they can go.
We can put this to the test and look back at how these Value-oriented ETFs have performed vs. the broader total stock ETFs.
Value ETFs vs. General Market ETFs
Let’s look at the most popular value ETFs vs. the most popular broad stock market ETF, VTI.
First, we have VTI vs. IJJ. IJJ is a mid-cap S&P 400 Value fund.
Here is how it has performed vs. VTI since the end of 2001. This is a hypothetical investment of $10,000 made at the end of 2002.
Here is the quick summary of the results.
Mid-cap value ETF has consistently outperformed the total stock market ETF VTI.
Is it the value aspect or the fact that ETF buys mid-cap companies? Mid-caps have benefited from having a larger exposure to the U.S market. 60% of their revenues is derived in the U.S. However, larger companies are more exposed to the international markets, making them more prone to supply chain disruptions and less susceptible to optimism about the U.S economy.
VTI vs VTV
Not all value ETFs are made the same. Industry focus, company size and overall composition are as important as the overall ETF strategy. So, let’s run another test comparing the two biggest total stock market and value ETFs, both offered by Vanguard.
Here are the results of a hypothetical $10,000 investment made at the end of 2004.
Summary of the results.
Again, Value ETFs are not funds that invest in what we would consider value stocks. You are better off investing in individual stocks that sell at a discount to their true intrinsic values. Unfortunately this strategy requires significant amount of work and no one ETF will be able to replicate it. That is because finding true value is as much art as it is science.
What are Growth Stocks?
Growth stocks are stocks of companies that expect to grow faster than average. Some definitions will say that companies that grow both revenue and profits are considered growth stocks but that is not really the case. Many growth stocks do not make money, because they grow. Growth requires capital and if the company generates enough cash flow it can reinvest the cashflow into growth.
Other ways these companies achieve growth is by significantlyt underpricing their competition in order to gain market share. This can lead to short-term losses however.
Why growth stocks typically lose money?
Well there are many reasons. One, these companies can be incredibly inefficient. Not all but it is a possibility. Two, they burn through cash or significantly underprice. Here is a quote from Jeff Bezos from Amazon’s 2005 Letter to Investors
“As our shareholders know, we have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible. This is an example of a very important decision that cannot be made in a math-based way. In fact, when we lower prices, we go against the math that we can do, which always says that the smart move is to raise prices. We have significant data related to price elasticity. With fair accuracy, we can predict that a price reduction of a certain percentage will result in an increase in units sold of a certain percentage. With rare exceptions, the volume increase in the short-term is never enough to pay for the price decease. However, our quantitative understanding of elasticity is short-term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or ten years.“
The idea here is that having low prices and, in many cases, a LOSS on the income statement has long-term benefits that are impossible to quantify.
The idea is that instead of sharing efficiencies with shareholders through dividend payments or share buybacks, the company chooses to share efficiencies with the customers. Customers reward the company with increased sales, referring friends, and driving growth. Growth produces more economies of scale for the businesses, and once again, the company passes the benefit down to the customer. That is the main difference between value vs. growth stocks. Value stocks typically don’t fall into this category.
Value vs. Growth Stocks ETFs
Let’s compare the performance of some of the most popular growth ETFs with broader market ETFs and their value counterparts.
We are starting with Vanguard’s funds first.
VTI – Total Stock MArket
VUG – Growth ETF
VTV – Value ETF
VTI vs. VUG vs. VTV
From 2004 pretty much until 2016, Growth ETF (VUG) has performed identical to the value and broad stock market ETFs. Then in the last 5+ years it has significantly outperformed both.
Here is the summary:
Technology stocks, especially newer tech companies, fall under the growth stock category. These companies don’t necessarily make money because they are trying to capture the market. They come up with some new technology that the market is testing.
There has been a boom in ETFs that specifically focus on this type of company. One of the most discussed in 2021 is Cathie Wood’s ARKK.
Here is how ARKK performed compared to VTI. ARKK blew past VTI, thanks to a handful of stocks that have delivered truly abnormal returns over the last few years. These include TESLA, ROKU, SQUARE and others.
Here is the summary:
That is an incredible 7x return or 35% CAGR over such a short period, but the question after such performance is, can it last? As the price of these companies rises, we cannot expect to see the same rate of return in the future. When writing this in July of 2021, we live through one of the longest bull runs in history. Remaining blindly optimistic for the future can be seen as foolish. There are warnings about the potential crash of these stocks that might be looming as these companies show bubble-like traits.
Value vs. Growth Stocks. What should I choose?
When choosing value vs. growth stocks, you have to consider your overall portfolio goals and risk tolerance. Value stocks can be more prominent companies that are overlooked by the general public but are typically profitable. On the other hand, growth stocks are not necessarily profitable, with debt and losses that last for years but they do show high capital gain potential. Eventually, growth stocks should turn into boring larger capital companies that due to their size cannot produce the same rate of growth.
There are periods where growth stocks significantly outperform the general market, but the value is always there to be found for people who look. When purchasing value stocks, you buy quality at a discount. When purchasing growth, you understand the future and see how the company will be able to fulfill its potential.
The nature of growth stocks today makes them extremely popular for speculators. We always encourage you to consider the PRICE that you pay, even if the company has very rosy future potential.