There are plenty of ways to classify stocks to help you refine your investing strategy. One helpful method is to focus on growth stocks vs value stocks. Growth stocks tend to be growing at rates significantly above the average for the market, thanks to their unique products or disruptive technologies.
What Are Growth Stocks?
Growth stocks are companies that are growing their share prices, revenue, profits or cash flow at faster rates than the market at large. Investors choose growth stocks to earn profits from the rapid price appreciation they offer, rather than income from dividends.
“Growth stocks represent companies exhibiting strong revenue and earnings growth rates, largely irrespective of what the economy is doing around them,” says Phil Kernan, CFA, a portfolio manager with Mitchell Capital.
Growth stocks are very often smaller, newer companies, or industry disruptors. Whatever their size or age, growth companies usually offer unique services and products, and frequently own novel technologies or intellectual property that puts them ahead of other companies in the same industry.
“Growth stocks aren’t always the companies who think of an idea first; Amazon wasn’t the first company to sell products online,” says Kernan. “The best growth stocks are those that took an existing idea and figured out how to scale it in a meaningful way.”
Growth over Dividends
By and large, growth companies reinvest their earnings and take on debt to rapidly expand. That’s why they are called growth stocks: They’re constantly ramping up production, acquiring other businesses and hiring lots of new employees.
For these reasons, growth companies seldom pay dividends. But investors who buy growth stocks aren’t looking for dividends—they’re hunting for exponential growth.
From 2020 to 2021, for instance, Amazon’s (AMZN) stock price increased almost 65% from $2,008.72 to $3,313. That’s impressive year-over-year growth almost anytime, much less during a pandemic year. What’s more, though, Amazon grew a mind boggling 1,500% in the previous decade. That’s the kind of huge gain growth investors are after.
All this growth doesn’t come without commensurate risks. Growth stocks can lose a significant amount of value quickly if the company runs into trouble or the overall market environment turns.
“Growth stocks are exposed to more crash risk and volatility than value stocks,” says Dr. Derek Horstmeyer, associate professor of finance at George Mason University’s School of Business.
Amazon is flying high these days, but two decades ago it lost over 90% when the dotcom bubble burst. It took almost a decade for the stock to equal its former high.
Growth Stocks vs Value Stocks
On the other end of the investing spectrum from growth stocks are value stocks. Value stocks are companies that are undervalued by the market—value investors like to call them stocks that are on sale.
Investors buy value stocks in the hope that other market participants will eventually realize that the stocks are undervalued, buy the shares and drive prices higher. Value companies aren’t always focused on growth, so they’re more likely to pay dividends. They have lower levels of risk, tend to be less volatile but also offer more limited upside potential.
Historically, growth stocks perform best when interest rates are falling and company earnings are on the rise. When the economy begins to decline and the cheap money that often fuels fast growth becomes more difficult to find, growth stocks can be severely impacted.
By contrast, value stocks do well during the early stages of economic recovery due to their healthy fundamentals. Their core businesses are self-sustaining enough that they aren’t seriously compromised when the broader economy takes a sharp turn—that’s when growth companies with lots of debt tend to struggle. That said, as a bull market drags on, value stocks may begin to lag growth stocks.
In recent years, growth stocks have outperformed value stocks significantly. The Vanguard Russell 1000 Growth ETF, which tracks the performance of hundreds of leading growth companies in the U.S., saw an average annual return of 17.06% from 2010 to 2020. Its counterpart Vanguard Russell 1000 Value ETF, on the other hand, clocked in with annual growth of 0.37% over the same period.
Recent performance, though, is no indication of future success. Many experts view the relationship between growth and value stocks as rotational. One performs better than the other for a period. Then the tables turn and the other takes the lead. The challenge for investors is determining when this change happens. As with many things in investing, this can be difficult to predict before it happens, which is why many experts advise investors to put money into a mixture of both.
How to Find Growth Stocks
If you decide to invest in growth stocks, it can be hard to identify the right growth companies. When evaluating potential stocks, consider the following factors:
- Emerging trends. Changing societal trends can have a huge impact on growth stocks. For example, the coronavirus pandemic caused a renewed focus on home fitness and health companies, so brands like Peloton (PTON) saw enormous gains; in the fourth quarter of 2020, Peloton’s total revenue grew 172%, and over the course of 2020, its stock near-quintupled from $32.36 per share to $146.13.
- Profitability. Companies that are already turning profits tend to be less risky than companies that haven’t yet made money. Investors generally assess current earnings by looking to a price-to-earnings (P/E) ratio that compares current stock price to company earnings. Growth companies tend to have higher P/E ratios, meaning their stock is priced significantly higher than average based on company earnings. To position yourself to benefit from their growth, then, you’ll have to pay a premium based on the amount they currently take in. However, you may want to stay away from companies that aren’t profitable at all yet.
- Analyst predictions. Countless stock market experts analyze companies’ performance and predict their future growth. While experts can be wrong, keeping analyst projections can help inform your decisions.
- Balance sheet health. While it’s common for companies to take on debt—especially when they’re expanding—companies that are severely indebted may run into trouble. When reviewing a company’s balance sheet, look for a debt-to-equity ratio under 30%, though this benchmark may vary from industry to industry.
To simplify the research process, you can use stock screening tools like those available at your online brokerage to filter factors like a company’s P/E ratio, price and industry.
However, if you’re worried about conducting all of this research yourself or putting your entire investment into one company, which can be risky no matter if you’re investing in growth or value stocks, consider a broader approach: Invest in mutual funds and exchange-traded funds (ETFs) that contain hundreds of growth stocks instead.
“The cost to invest in ETFs that track growth stocks is at a historic low and basically near zero for the most popular ETFs,” says Dr. Horstmeyer. “This is way more cost efficient than going around and buying up stocks via the average brokerage account.”
By investing in multiple companies at once, you’re diversifying your portfolio and lessening your risk while still positioning your dollars to grow as growth stocks do overall.
How to Fit Growth Stocks into Your Portfolio
When investing in growth stocks, consider your goals and risk tolerance. Growth stocks are best for investors saving for long-term goals—such as retirement—with a high risk tolerance; they’re generally not best for investors close to retirement age or those that need to generate income.
“For investors with a long-term horizon who are comfortable with some volatility, growth stocks should play a core role in portfolio allocation,” says Kernan. “Additional asset classes such as value stocks can be added around that core to increase diversification and help dampen volatility.”
Ultimately, determining whether to invest in growth stocks vs. value stocks is a personal decision. When deciding what is best for you, make sure you’re comfortable with the initial investment required (if any), the level of risk associated with your investment and how it fits into your financial goals. If you need help deciding on what stocks or funds to invest in or what the right allocation is for you, consult with a financial advisor.