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Do you need to choose between growth stocks and value stocks?
Growth and value are two types of stocks, each pregnant with virtuous sounding meaning. “Value” conjures up notions of sturdy, fairly priced products—perhaps even a bargain. “Growth,” on the other hand, stirs up images of a well-cultivated victory garden, ready to bestow its fruits to its owners. But neither approach to selecting stocks is based simply on sensibilities, even though they may appeal to your inner bargain hunter or green thumb. Value-fund managers are looking for stocks with particular characteristics, many of which differ from those that growth-fund managers are hunting for.
It’s about the metrics
The primary metric used to distinguish a growth stock from a value stock is the company’s price-to-book ratio. Price-to-book is the current trading price of the company’s stock divided by the company’s book value per share. Book value, to somewhat simplify, is a company’s assets minus any liabilities it may have—for example, bonds it may have issued or interest payments it’s making.
The higher a stock’s price-to-book ratio, the more growth oriented the company tends to be. Conversely, the lower the ratio, the more value oriented it is. But there’s no hard-and-fast price-to-book ratio that suddenly turns any stock into a growth stock or defines it as a value stock. Instead, a stock’s price-to-book ratio is measured relative to others to determine which camp it falls into. Price-to-book ratios will broadly rise when markets are doing well (because rising stock prices increase the numerator—“price”—of price-to-book) and fall during market downturns.
Although price-to-book is the primary metric that separates growth stocks from value stocks, the fund rating agency Morningstar looks at other common ratios, including price-to-sales and price-to-cash flow. It also considers a stock’s dividend yield to determine whether it is more value oriented. It looks at earnings growth, sales growth, cash flow growth, and book value growth to determine which companies are more growth oriented. Using those measurements, very few stocks turn out to be purely growth or value. Most have characteristics of both.
Looking at commission-free growth or value exchange-traded funds? Consider the costs.
While those kinds of metrics are useful in determining whether a stock is more growth oriented or more value oriented, there are certain types of companies that will always be pegged one way or the other. Among big value stocks are AT&T, Exxon Mobil, General Electric, Procter & Gamble, and Wells Fargo—which are the 10 largest holdings of the iShares Russell 1000 Value exchange-traded fund. Those stocks tend to belong to mature companies, and their shares pay higher-than-average dividends—the yields of those five stocks currently range from about 2.5 to 5.6 percent. The average price-to-earnings ratio of stocks in the Russell 1000 Value index is 17.8—lower than that of the overall market of 19. The price-to-book ratio is also lower: 1.9, compared with that of 2.9 for the broader market.
Meanwhile, growth companies include the likes of Apple, Coca-Cola, Google, and Verizon, which are among the 10 largest holdings in the iShares Russell 1000 Growth ETF. The dividend yields of those kinds of firms tend to be lower than those of growth companies (and in the case of Google, nonexistent). And the price-to-earnings and price-to-book ratios are significantly higher as well.
Market leaders
Based on those metrics, one might conclude that value stocks are the smart way to go and that growth stocks are overpriced, faddish things cruising for a bruising. But that’s not always the case.
Although growth stocks will almost always seem more expensive than value stocks, the two take turns leading the market. Since the end of the 2009 recession, for example, growth stocks have decidedly outperformed value stocks, returning 15.5 percent annually, as measured by the Russell 1000 Growth index. Over the same time, value stocks have returned less—13.4 percent annually as measured by the Russell 1000 Value index. But in the prior decade, value stocks trounced growth stocks, returning 2.5 percent annually from 2000 through 2009, and growth stocks lost 4 percent annually.
Going back even further, in the 1990s many investors were falling over themselves to buy more shares of growth stocks such as Microsoft and Motorola and questioning whether famed value investor Warren Buffett, who avoided such companies, had lost his edge. But if you look back over the very long term—at least 40 years— value stocks have been the bigger winners.
Consider the costs
Given that both kinds of stocks can have long winning runs, how should you choose what kind of stocks are best for your portfolio? Consider the costs of value and growth ETFs as well as the cost of just buying the broader index. The iShares Russell 1000 Growth ETF and iShares Russell 1000 Value ETF, for example, each sport an expense of 0.20 percent annually. Though that’s cheap, it’s not as cheap as the plain ol’ iShares Russell 1000 ETF (ticker IWB), which tracks the index and costs investors only 0.15 percent annually.
If you invest in actively managed funds, there are more distinctions to make. Value stock funds generally cost less than growth stock funds. The primary reason: turnover. Growth-fund managers generally hold stocks for a shorter period of time than those of value investors, some of which, like Bruce Berkowitz’s Fairholme Fund, have incredibly low turnover. Ultimately, the costs of the additional buying and selling of shares gets passed on to fund shareholders in the form of a higher expense ratio. According to Morningstar data, the average actively managed large-cap growth stock fund cost investors 1.21 percent annually, more than the 1.14 percent average of an actively managed large-cap value stock fund.
Our suggestion: Don’t make a choice. To give your portfolio the greatest chance of high returns, you don’t need to be either a value investor or a growth investor. A better strategy is to buy both kinds of stocks. Also, be sure to keep the stock portion of your investments as diversified as possible. The best way to accomplish that is to simply purchase a broad-based index fund. By doing that, you’ll get both value and growth while incurring the least cost.
This article also appeared in the August 2015 issue of Consumer Reports Money Adviser.
Consumer Reports has no relationship with any advertisers on this website. Copyright © 2006-2015 Consumers Union of U.S.
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