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What Is The Difference Between Growth Stocks and Value Stocks?

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by Gavin in Blog
June 16, 2020 0 comments

Contents

Introduction

One of the great things about trading is that there are so many different styles and methods that you can use.

This means that despite traders having different biases, preferences, availability, capital, risk tolerance levels and philosophies, there is sure to be a trading style for them.

One fundamental concept in trading that can drastically influence a trading style, is whether to trade in growth stocks, value stocks, or even both.

This is because these are fundamental properties of how particular stocks behave and therefore will appeal to different traders with different risk tolerance levels, philosophies and preferences.

This article will explore the difference between growth stocks and value stocks, describing what they are and how they are differentiated.

What Are Growth Stocks?

Put simply, when traders refer to a growth stock, they generally mean stocks that are expected to grow faster than what an average stock would.

There is no hard and fast rule about what constitutes a growth stock, but in general there are a set of metrics that traders generally consider the best indicators.

Note that a trader may use some or all of these metrics in their definition of a growth stock.

These metrics are:

  • Sales
  • Earnings
  • Cash flow
  • Book value
  • High valuations
  • High price to earnings ratios
  • A fast-growing industry

Generally speaking, a trader will look for stocks that are experiencing, or are about to experience, high growth in sales, earnings, cash flow and book value, as well as those belonging to a fast-growing industry like AI or cloud computing.

As a result of these fast-growing metrics being satisfied, often growth stocks will have high valuations and high price to earnings ratios.

For example, Vanguard, one of the largest fund managers in the world, has a Vanguard Growth ETF.

As at April 27, 2020 the top five holdings were Microsoft, Apple, Amazon, Alphabet and Facebook.

All five are fast-growing industries with many of the metrics described above experienced healthy growth.

For example, despite the coronavirus ravaging markets by more than 30% at the time of writing, Microsoft still trades at a very high P/E ratio of 25.5, despite the broader market (as represented by the S&P 500) trading at 15.8.

Despite the top Vanguard growth stocks all being large-cap stocks, it doesn’t mean that growth stocks are exclusively large-cap.

There are many found amongst mid and small-cap stocks and in fact, you’re more likely to find growth stocks amongst lower cap stocks as they generally have more room to grow given their agile nature and exposure to innovation.

What Are Value Stocks?

When traders refer to value stocks, they generally mean finding stocks that are trading for less than they are actually worth.

That is to say, they are getting value for money by buying a stock whose price doesn’t actually reflect their underlying worth.

Click Here For My Top 5 Technical Indicators

For example, during the Global Financial Crisis, many banks in the US and around the world were sold off aggressively as people feared they would collapse.

In some cases, the prices of these banks on the stock market were at a discount of 50% or more than the value of mortgages and deposits they held!

For value investors, moments like the GFC are prime buying opportunities when they can essentially buy $1 worth of assets for $0.50 or less.

However, most of the time markets aren’t crashing and are in fact going up. So for value traders seeking opportunities, the way they find these stocks is different.

During normal times, traders will carefully comb through a company’s detailed financial statements and conduct their own analysis about future trends to create a picture of whether the market hasn’t realized the full potential of the stock.

By buying these value stocks, the trader is hoping that eventually the business results (such as earnings and profits) will continue to grow and match their future projections, at which point the stock will come to the attention of the broader market.

As soon as the broader market is aware of the stock, they will quickly buy it until it reaches “fair value” – that is to say, the stock price reflects what the business is worth.

When searching for value stocks, they can be easily found during market crashes like the GFC, but during normal conditions you’ll have the best luck in small-cap stocks.

There are too many for all investors to be across and so they don’t have the same detailed coverage as the large caps, meaning opportunities for miss-pricing will be higher.

Growth Or Value – Which Is Better?

Growth stocks tend to be more expensive due to their high valuations and are often seen as riskier – traders pay a premium to hold onto these stocks in anticipation of continued fast-moving growth.

Whereas value stocks are less expensive and often seen as less risky, as you’re effectively buying a business at a discount to its actual value.

In both cases, traders can be wrong about a company’s prospects. Unforeseen events can derail a company’s growth completely while value stocks may always stay cheap as the markets don’t see long-term potential in it.

As a result, neither growth nor value stocks are better than each other.

Each type of stock will require different analysis, risk tolerance and philosophies.

This is great news for traders as it means you you can pick one based on your own preferences and you can make it work.

In fact, you could trade both if you wanted to, as long as you ensure you apply appropriate (and often different) methodologies in your analysis.

Conclusion

There are many different ways to trade stocks and one of those is based on the fundamental behavior of two types of stocks – growth stocks and value stocks.

Growth stocks represent fast-moving stocks, experiencing high growth across key metrics such as sales and earnings, while value stocks represent undervalued stocks, which are trading at less than they are possibly worth.

No one type of stock is better than the other.

Traders should choose whichever one best meets their risk tolerance, philosophies and preferences.

They can also choose to trade both by applying different methodologies and approaches.

Trade Safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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