What Are Growth and Value Stocks?

– December 14, 2015 Reading Time: 3 minutes

When I started my first job with a 401(k) plan, I remember looking at the options and seeing these words in the fund names: Value and Growth. I had some investing experience, so I knew that I should diversify across asset classes. But it sure was tempting to pick those funds with the flashy names. Something like “Goldman Sachs Growth Opportunities” sounded so promising. As it turns out, those titles aren’t terrific indicators of how well funds might perform.

Funds that invest in growth stocks buy companies that are more expensive, whereas value funds buy stocks that are relatively cheap. How do we gauge whether a stock is cheap or expensive? We compare the total market value of the company (total number of shares times the share price) against the company’s earnings or book value.

Why are some stocks more expensive? Investors drive up the price of a stock when they think that the company has better growth prospects, hence the “growth” moniker. On the other hand, companies with more modest growth prospects may not have as much investor demand, making the price relatively low. Those are value stocks.

Growth stocks include companies like Facebook, Tesla, Starbucks, and Amazon – high fliers with big growth potential. But everyone knows it and their prices reflect that huge potential. Value stocks are often mature companies like Ford Motor Company, AT&T and Best Buy. The growth prospects are more limited, but the prices of value stocks reflect that pessimism.

How does all this play out in terms of expected returns? With available data since 1979, it turns out that value stocks, the companies that are cheap with fewer growth prospects, have returned about 1 percent more per year than the companies with the best growth prospects. This happens because the market is so efficient that lots of investors will buy companies with the best growth prospects, driving their prices up and expected returns down.

People like Warren Buffett focus on value stocks – those that he believes are selling at a discount. These companies just need to grow at a modest pace in order to outperform expectations and potentially drive their prices up. This has become known as the value premium, as first formulated in a 1992 research paper by Eugene Fama (of recent Nobel fame) and Kenneth French.

Historically, value stocks have offered a long-term premium if you are willing to tilt your portfolio in that way. Theoretically, this premium comes from the higher risk associated with companies that are expected to perform worse than their peers. Now, this value premium will not always pan out. When you look at the last several years or the 1990’s, growth stocks significantly outperformed value stocks. Generally speaking, however, you should hold a mix of value and growth stocks, which you can achieve just by holding a market portfolio. But if you’re looking to increase long-term returns and potentially take on a little more risk, you can tilt your portfolio toward value stocks.

Practically speaking, if you’re trading within a retirement plan with limited options, you’ll need to figure out which funds are growth, value, or neither. It’s often easy to tell based on fund names whether they focus on growth or value, but sometimes it can be difficult to tell.

Growth funds sometimes use the word “opportunity.” Both value and growth funds sometimes leave the moniker out of their names entirely. For instance, the “Northern Large Cap Core Fund” is a value fund, but you wouldn’t know it from the title. Likewise, the “Parnassus Fund” is a growth fund with no indication of such in the title.

The best thing to do when evaluating your investment options is to take a look at the Morningstar.com summary of the fund. You’ll see the “category” and “investment style” on the front page. If you’re planning to tilt your portfolio one way or the other, monitor your allocation based on these broad categories.

While you’re on the Morningstar page, check the fees as well, listed under “expenses.” You might as well do your best to pick the lowest-cost funds.