Growth stocks vs. Value stocks

Whats the difference? Also, over a long period, say, 5-10 years, which will make more money?

The reason I ask is because I’ve got about 20,000 dollars sitting in a money market account, getting about 1.5 percent interest, that I want to invest in mutual funds. I plan on investing in index funds, as I don’t have a lot of time to keep track of my investments. I also plan on keeping the money in the funds for the long term, several years.

All sorts of info on stock and fund types.

As for which would make more money over 5-10 years, no one knows. If they did, there’d only be one type of fund.

The names are surprisingly descriptive. Typically, one buys a “value” stock because it is a good solid company that the market just doesn’t like all the much, perhaps simply because it’s boring. A “growth” stock is a company you buy not because it’s making money now, but because you feel the company’s going to grow.

The classes are differentiated in practical terms by their P/E ratios, that is the Price of the stock divided by its annual Earnings. A stock with a market price of $10 and earnings-per-share (eps) of $1 has a P/E of 10; one with the same price and eps of $0.10 has a P/E of 100. You buy the latter because you expect that company to grow; for instance, you might think that demand for its product will increase sufficiently that in 10 years that same single share might represent $10 in earnings, while the boring former company will still be chugging along at $1/share. It’s the whole bird-in-the-hand phenomenon. Be careful, though! A stock which has an apparent P/E ratio of 10 (based on trailing earnings) might be a “growth” company with a price that has recently collapsed due to half of their business just becoming obsolete … or any number of things that can possibly happen to a company. Picking a good company is as hard as picking a good friend: appearences can be deceptive and you can do all the work you like and still be fooled.

There has been some research indicating that value stocks do better in the long run - a counter-intuitive finding because one would expect that the greater risk of “growth” stocks would bring with it greater expected returns. I can’t provide any references at the moment, but try “The Financial Analysts Journal” published by AIMR, the Association for Investment Management and Research. I think the paper I’m thinking of was published in 1998 or 1999. I also think Valueline has done some work on this.

You can make logical sense of this finding only by assuming that investors want risk - they would much rather take chances in the hopes of doubling their money quickly. Growth stocks will also bounce around in price a lot (as market perceptions of their future growth change with every quarterly number) and the average investor naturally thinks he’s above average and will be able to get out at every top and buy back in at every bottom.

There are a number of good advisors out there - try a “fee-for-service” one who’ll look at your whole financial situation and come up with a plan, with explanations. In Canada, we have the Canadian Securities Institute which provides a good basic course on investing, while AIMR (at is a global group based in the US which provides a very highly regarded three year correspondence course.

There really isn’t any standard definition, but, in general, growth stocks are those which tend to have better earnings prospects, higher price-to-book (P/B) ratios, higher price-earnings (P/E) ratios, higher price-to-cash flow (P/CF) ratios, higher price-to-sales (P/S) ratios, higher sales growths, and lower dividend yields than value stocks. If you will, growth stocks are considered “glamorous”, while value stocks are usually considered to be “out-of-favor”. But mutual fund managers can use whatever definition best suits their needs.

For an investment horizon that short, there’s no telling which style will perform better. In fact, you really can’t even be sure that either style will perform better than the 1.5% you’re getting in the money market account.

That having been said, there has been a tremendous amount of evidence produced over the past decade which has shown that value stocks (defined as the bottom 30% of stocks based on P/B ratios) perform substantially better than growth stocks. The “value premium” appears to be almost as large as the equity premium (the difference between stock market returns and bond market returns), and just as persistent. University of Chicago Finance Professor Eugene Fama and Dartmouth College Tuck School of Business Finance Professor Ken French’s Characteristics, Covariances, and Average Returns: 1929-1997 (pdf) proved this. Similar studies found a very large value premium in developed and emerging markets all over the globe.

A breakdown of the source of the value premium by P/B deciles is shown here.

And here are the returns of growth vs. value for the past 37 years and 74 years.

The only question that remains is why? The reason for the value premium appears to be compensation for increased risk. Value stocks have been shown to have higher ratios of debt to equity and a higher standard deviation of earnings.

You’re definitely ahead of the game. Only 10% of investors are smart enough to figure out that the odds of beating the index are slim in a tax-deferred account, and nearly impossible for a taxable account.

If this is taxable money that you will be investing in a lump sum, you might be better off using Exchange-Traded Funds (ETF’s), as they slightly are more tax-efficient than regular index funds.