Growth Vs. Value Investing Explained – Forbes Advisor UK

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Growth investing and value investing are two different investment styles. The former targets shares that have the potential for above-average earnings growth, while the latter focuses on shares that are perceived to be trading below their intrinsic or ‘real’ value.

Last year proved to be far more favourable for value than for growth investors. Growth-heavy US stock market indices plunged into the red after the technology bull run went into reverse. In comparison, value-oriented portfolios fared much better, bucking the general stock market malaise to deliver modest gains. 

It has been all-change again in 2023, with growth shares firmly back in the limelight after posting some stellar gains while value shares foundered. As a result, it’s been challenging for investors to keep faith with long-term investment principles in the face of significant volatility.

To help navigate through the options, we take a closer look at value versus growth investing, and when investors might want to consider rebalancing their portfolio.

What’s the difference between growth and value investing?

As the name suggests, growth shares have the potential to achieve growth that outpaces the market average. These often include companies at the leading edge of technological developments or pioneers of innovative products and services. 

The underlying principle is that a company’s superior revenue and earnings growth should drive a larger increase in its share price over time. This means that investors are willing to pay higher valuations for growth shares now, in the expectation of future rewards.

In contrast, the defining characteristic of value shares is the belief that their current share price is lower than the ‘real’ or ‘intrinsic’ value of the company. In other words, they’re regarded as assets trading below their true worth – ‘hidden gems’, if you like.

Andrew Williams, investment director at Schroders, says: “Value investing involves companies that have suffered a severe setback in either profits or share price, but where long-term prospects are believed to be good and, therefore, potential shareholder returns are attractive.

“These investments can be out of favour for many reasons, including weak short-term profitability, economic concerns or an under-strength balance sheet.”

As a result, advocates of value investing believe that the company’s share price will increase as the valuation rises to reflect the intrinsic value of the company. 

What are the key characteristics of growth and value shares?

One way of differentiating between growth and value shares is to compare their price-earnings ratios, as follows:

• Growth: higher price-earnings ratios, often above 25 times and sometimes considerably higher. Investors expect a high level of growth in earnings and are therefore willing to pay a higher price relative to the company’s current earnings.
• Value: lower price-earnings ratios, often around 10 to 15 times (or lower), indicating that the market is valuing the company at a lower multiple of future earnings. 

Another difference is dividend yield (a proxy for the annual return in income, calculated by dividing the dividend per share by the current share price):

• Growth: generally have low, or zero, dividend yields, as excess cash is reinvested in the business to drive future earnings growth.
• Value: typically have higher dividend yields, often upwards of 5%, providing an income for investors as well as the potential for upside from share price growth.

Finally, some sectors have a higher proportion of growth or value shares:

• Growth: more prevalent in the technology, communications and biotechnology sectors.
• Value: often found in the financial, consumer staples and energy sectors.

Looking at an example of a growth company, the share price of semiconductor maker NVIDIA has increased by 245% in the last year, but has significant volatility with a one year high-low range of $503 to $108. It pays a very small dividend and is currently trading on a price-earnings ratio of 100 times.

Turning to a value company, Barclays’ share price has been flat over the past year. However, it has much lower volatility with a one year high-low range of 199 to 128 pence. It also offers a dividend yield of almost 5% and is currently trading on a price-earnings ratio of 5 times.

What are the benefits and risks of growth investing?

One of the main benefits of investing in growth shares is the potential for higher share price returns if companies succeed in delivering above-average earnings growth. Growth shares also tend to outperform during favourable economic conditions when investor confidence is high. 

However, the performance of growth shares can suffer when interest rates rise, as has been the case over the last two years. One method of valuation is to look at the ‘present value’ of a company’s future cash flows by applying a discount rate, which, in its simplest form, is the cost of borrowing money. 

Higher interest rates increase the discount rate used in this calculation, which reduces the present value of future cash flows and, by extension, the company’s valuation.

An economic downturn can also prompt investors to de-risk their portfolios by reducing their holdings of growth shares, which also puts downward pressure on share prices.

In addition, growth shares are typically more volatile than value shares. Investors have high expectations of earnings growth, and if a company fails to achieve forecast earnings, this can lead to a significant fall in share price.

What are the benefits and risks of value investing?

One of the key advantages of value shares is the opportunity for price appreciation if their share price is re-rated to reflect the company’s intrinsic value. 

Schroders’ Andrew Williams says: “Most investors will focus heavily on the bad news, but even in the most challenging economic times, insolvency is rare. 

“Historically, the market underestimates the ability of businesses to improve their situations over time and, as a result, investors willing to take a long-term investment view can benefit from very strong returns.”

Value shares also typically perform better in an economic downturn, particularly those with resilient business models in more defensive sectors. In addition, value shares often pay attractive dividends which may appeal to income-seeking investors.

However, Mr Williams adds: “The main downside to this approach is that we never know how long it will take for the market to recognise the value in a company and returns can be volatile over short time periods. 

“Value investing is inherently contrarian, and we believe that the best investments are found by going against the crowd. While volatility can adversely affect the fund in the short-term, it is also the source of our long-term outperformance. This is an approach for the long-term, patient investor.”

How have growth and value shares performed?

As mentioned earlier, growth shares generally outperform in favourable economic conditions but lag in an economic downturn. This is illustrated in the chart below:

Growth shares started to outperform value shares from early 2020, but this trend reversed in late 2021. This shift signalled a deterioration in economic conditions, driven by a rise in inflation and interest rates. As a result, investor sentiment pivoted toward more defensive options.

Subsequently, there’s been a resurgence in growth shares in 2023, primarily driven by mega-cap technology companies such as NVIDIA and Meta. Investor sentiment has become more optimistic on the hope that interest rates may be stabilising.

Darius McDermott, managing director of Chelsea Financial Services, says: “Growth shares have really been dominant for the past decade or so since the global financial crisis and monetary easing. 

“However, we had a sharp reminder in 2022 that a rising interest rate environment is not good for growth stocks, especially those that are already expensive on an historical basis. 

“We have seen growth stocks bouncing back in 2023 but it’s important to acknowledge that the S&P 500 in particular has been driven by just seven stocks (which are again expensive). If you take out these seven stocks from the equation, growth and value are more in line in terms of performance.”

When should investors consider rebalancing their portfolios?

The balance of growth to value shares in a portfolio depends on an individual’s investment objectives, attitude to risk and general stock market conditions. 

‘Buy and hold’ investors may favour a diversified portfolio of both growth and value shares, which helps to smooth returns across economic cycles and reduces the overall volatility of the portfolio. 

Chris Metcalfe, chief investment officer at IBOSS, says: “Given the retreat of globalisation and, with the same rationale as applied to the change of interest rate environment, we suggest investors look for investments that will thrive in this new world order. 

“Given the levels of unknowns geopolitically and, therefore, for asset prices, we think this is a time for maximum geographical and risk asset diversification.”

However, the wide disparity in the current valuations of growth and value shares may also tempt investors to tilt their portfolios more towards a value bias.

Schroders’ Mr Williams says: “Value’s median discount to growth has been 42% since 1975 but, despite value’s stronger run of performance over the past three years, it still trades at around a 60% discount to growth, and far below the long-term median. 

“The elastic band between the loved and the unloved parts of the market remains very stretched by any historical standards and is a long way from returning to more normal levels.”

Mr Metcalfe adds: “Our portfolios are tilted toward value and have been so for the last two years. Simply put, the assets that did well up to the beginning of 2022 may struggle. 

“For example, growth stocks that enjoyed such a strong run might not look attractive in99 higher inflation, interest rates, and a higher US Treasury yield environment. In contrast, many value companies, including some of the biggest dividend payers, will often be less affected by rates, and they also have better entry price levels than their growth peers.”

In terms of portfolio allocation, Chelsea’s Darius McDermott says: “If we accept that it is difficult to time these pivots, it’s an idea to hold some of each. That doesn’t have to be a 50:50 split but some allocation to each is sensible. 

“Given that we think we are nearer to the end of the rate rising cycle than the beginning, we have a slight bias in favour of growth today but are mindful that the seven mega-cap US stocks are on high valuations. A tilt to growth of say 60:40 or 65:35 seems reasonable at this stage.”

What are the limitations of growth vs value investing?

In reality, it’s not always possible to classify shares as either purely growth or value, as they may exhibit attributes of both.

Paras Anand, chief investment officer of Artemis, says: “There can often be a temptation to look at growth and value styles of investing in a two-dimensional way. 

“This assumes that value investors only look at cheap stocks, while growth investors are agnostic as to the prices they pay on the basis that companies that offer exceptional growth command exceptional valuations.”

Instead, he points to the importance of fundamental valuation in deciding whether or not to invest: “Only the analysis of the underlying company and its prospects relative to market expectations can give us any sense of whether the upside of a potential investment is attractive relative to the downside risk.

“As recent months have shown, market values can move a great deal (in both directions) in a relatively short space of time, so having entrenched views of which categories stocks sit in may prove to be a false friend.”