Growth vs value stocks: which have the highest returns?

What are growth stocks and how can you find value stocks? Here are a few ways to identify both of these. We look at previous trends to see which had the highest returns during different stages of the economic cycle.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
Stocks

The shares of listed companies can be categorised by investors as either growth stocks or value stocks. While both of these definitions are subjective, the criteria used to define a stock is generally based on a range of accounting metrics and ratios that financial analysts can use to screen for both of these types.

While a company may qualify as a value or growth stock based on its fundamentals, it is also important to look past the balance sheet and gain a strong understanding of other aspects of the business, such as the future prospects for the industry that the company operates in or the track record of the current management team.

What is a growth stock?

A growth stock is a company that has grown revenue at an above—average rate and is well positioned to continue to do so in the future.

But how to find growth stocks? The expectation of higher future earnings is usually reflected in a higher than average price to earnings ratio (P/E ratio). Other common indicators include strong revenue growth and a high earnings per share (EPS) ratio.

Investors who buy growth stocks should expect to make a return from future increases in the company’s share price, rather than from dividend payments. This is because growth companies should exhibit profitable reinvestment opportunities and therefore ought to look to reinvest their retained earnings back into their business rather than pay out profits to shareholders.

Example of growth stocks

The table below includes a few companies that have recently seen rapid revenue growth, which analysts expect to continue into the future given their elevated forward P/E ratios.

Stock name Ticker Recent price 12 month price return Annual revenue growth (based on most recent quarter) Forward P/E
NVIDIA Corp NVDA US $215.47 57.8% +40% 33.3
Square Inc SQ US $75.92 243.7% +48% 143.7
Wirecard AG WDI GY €166.28 141.5% +40% 47.3

Source: Bloomberg. Data at 30 September 2018

However, investing in growth stocks can be a double—edged sword. While these type of stocks have the potential to deliver above—average capital growth, as shown by the impressive returns in the table above, they can also exhibit higher share price volatility.

It is therefore important to consider diversifying your risk and not putting all your eggs in one basket. One option is to invest in an exchange traded fund (ETF), which invests in many companies in the industry or sector you are interested in.

For instance, ETF provider Global X offers a robotics ETF, while new entrant HAN—GINS offers niche exposure to technology.

ETF name Ticker Expense Ratio
Global X Robotics & Artificial Intelligence ETF BOTZ LN 0.68%
iShares S&P 500 Information Technology ETF IUIT LN 0.15%
HAN—GINS Innovative Technology ETF ITEK LN 0.75%

You can explore all the ETFs IG offers in our screener.

What is a value stock?

Value stocks are almost a mirror image of growth stocks. They are companies that may have fallen out of favour, but still have strong fundamentals. They may appear cheap relative to the wider market when looking at certain valuation measures.

While there is no universal definition for a value stock and no secret formula for finding them, it is recognised that these type of companies generally have low P/E and market—to—book ratios, as well as exhibiting high dividend yields.

One important consideration when seeking value stocks should be the liquidity and solvency of the company. If the company isn’t generating positive cash flows or has a large debt burden, they may be cheap for a reason.

Example of value stocks

In the table below we have listed a few large stocks that meet some of the criteria mentioned above. These are household names with strong business models, but have not seen the rapid rise in price that many technology stocks have seen in recent years.

Stock name Ticker Recent price 12 month price return Dividend yield Forward P/E
AT&T T US $25.75 —9.4% 6% 9.3
Exxon Mobil XOM US $65.19 7.9% 3.7% 15.8
JPMorgan Chase JPM US $86.52 20.7% 2.8% 11.9

While the names of the ETFs that track this type of company are admittedly less stimulating than the Global X Robotics & Artificial Intelligence ETFs’ of this world, there are plenty to choose from and they generally have a longer track record and lower fees. A few notable examples are:

ETF name Ticker Expense ratio
iShares Edge MSCI World Value Factor ETF IWVL LN 0.30%
Vanguard Global Value Factor UCITS ETF VDVA LN 0.22%
SPDR MSCI USA Value UCITS ETF USVL LN 0.25%

How have growth and value stocks performed over time?

Certain industries can become unloved by investors at different stages of the economic cycle, just as an individual company may become cheap relative to other firms operating in the same sector. To show this we have looked at the two decades that followed the 2008 global financial crisis and the bursting of the 1999 dotcom bubble respectively.

Since the 2008 financial crisis, traditional ‘value’ sectors such as financials and energy have lagged behind high performing growth sectors such as technology. The chart below shows how the MSCI World Growth Index has risen by over 86% more than the MSCI World Value Index since the start of 2009, with real momentum gathering at the start of 2017.

Growth sectors such as technology (which makes up 13.6% of iShares MSCI World ETF) have boomed in recent years, rising 61% since the start of 2017. Stocks like Apple (+101%), Adobe Systems (+147%) and Salesforce (+117%) have helped drive markets higher.

Over this period, financials (+19%), energy (+16%) and consumer staple stocks (+13%) also provided positive returns, but lagged behind the market return (+28%). The chart below shows total returns for each sector since the start of 2017.

But this has not always been the case. Just as bank stocks were neglected after the financial crisis, investors were also wary of tech stocks long after the dotcom bubble. Between 1998 and 2008, growth stocks underperformed value stocks by 54%.

In fact, over the 43 years dating back to 1974 (when the two MSCI indices were created), there is an almost even split between the years value stocks outperformed (23) and years growth stocks had higher returns (20).

What’s the outlook for growth and value stocks?

With such impressive growth, many of today’s growth stocks have become household names, just as they did in the build up to the dotcom crash in 1999. This time around, many niche ETFs have popped up to service retail demand for stocks, in exciting industries such as cyber security, artificial intelligence (AI) and robotics.

At the same time there have been cases of journalists and market commentators suggesting that we have entered a new age of investing and that value stock picking is now ‘dead’. We think this is just another case of market scaremongering.

We believe that value stocks will once again have their day. By contrast, there will be darker days ahead for some growth stocks as they become no longer able to justify current lofty market valuations based on expected future earnings.

In the next stage of the market cycle, there will be tech stocks that lose their shine, and the key to superior investment returns will be in positioning your portfolio to safeguard against falls in these type of stocks, but also finding opportunities in value stocks which have seen a decade of relative underperformance.

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