Though we at Henssler Financial have always classified our mutual fund recommended list into ‘Growth’ & ‘Value’ categories, and use these terms when talking to our listeners, the use of these terms is just now becoming widespread. The proliferation of these terms in the press is causing confusion, but fear not, we’ll put it into context for you!
To be certain, like many things in finance, there is no exact definition for these two terms. Rather, much of the distinction between these two terms is based upon one’s perception. But, of course, there is a rule of thumb. Typically, a ‘value’ stock is an equity that trades at a P/E below its estimated growth rate. The buyer of the value stock believes that this ‘discount’ will at least correct itself, presenting a profit opportunity. However, a discount to the growth rate does not necessarily signal buy. A stock can trade at a discount to its growth for a number of reasons including cyclical earnings, uncertainty as to the validity of the projected growth rate, or if the stock has a history of missing targets. Value stocks are typically found in the industrial sector (cyclicals), auto manufacturers, consumer cyclicals, and financials, largely because their respective earnings are tied to underlying commodities and the state of the economy.
On the other end of the spectrum, a ‘growth’ stock is typically an equity that trades with a P/E premium to its growth rate. The buyer of the growth stock believes that continued acceleration of supernormal growth in earnings will continue to maintain or even expand the premium P/E. Of course, the risk to the growth investor is that this P/E corrects to equilibrium, meaning the price declines. This can be as a result of earnings deceleration, failure to reach earnings targets, or just the normal gyrations of the market driving prices down. Growth stocks are typically representative of the technology sector, healthcare, and telecom. Most Internet stocks, despite having zero earnings, would be classified as growth stocks based upon other valuation metrics.
From a portfolio perspective, a ‘Growth Fund’ or a ‘Value Fund’ is simply just a portfolio comprised predominantly of stocks in the sectors that fall in one of these categories. Clearly, the composition of a portfolio is a bit more complex than this. Ratings agencies, including Lipper, employ a mix of quantitative measures in order to classify a fund in one category or another. For all intents and purposes, when you read a fund is of one category or the other, you should expect to find an abundance of the holdings substantially concentrated in one of the categories. In addition, a value portfolio may have some growth stocks ,but like a value stock, the portfolio should wind up with an aggregate P/E below that of its weighted average growth rate. The opposite is true for growth funds.
You should be aware that there are other ways to classify a stock (or FUND) as growth or value; much of which depends upon the perception of the investor. The important thing to remember is that growth and value are relative terms; investors can justify an asset as one or the other when considering it relative to some base, such as earnings, book value, peer group, cash flow, and more. Of course, don’t always take what somebody on TV or the paper says for granted; often times you must be skeptical. A very popular portfolio manager, for instance, claims that a particular stock is a value stock because it is cheap relative to its peers. We may argue, however, that its peers are overpriced, and on an earnings basis, for example, the stock is clearly a ‘growth’ stock. You can expect the Growth and Value terms to continue to gain attention in the popular press. Academic, as well as practical research, continue to present concrete evidence that these two classifications are a reality in the marketplace, with the two groups rotating in and out of favor per their classification. This research has widespread implications because it suggests that stocks can be observed moving in tandem. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].