Shares of Netflix tumbled as much as 39% the day after it reported a loss of a swell of customers for the first time since 2011. The loss of 200,000 customers in the first quarter was punished by investors, with the stock now the worst performer of the year on both the S&P 500 and the Nasdaq 100 indices.
It ignites the old toss-up between growth stocks — as represented by Netflix and other tech darlings that have dominated the market over the last decade — and value stocks, so defined as equities that have beaten down valuations that make them too cheap to ignore. In this article, we break down what value and growth stocks are, and why knowing how to differentiate them is key in today’s investing environment.
What are value stocks?
Value stocks are stocks that are currently trading at a lower price (cheaper valuation) relative to their earnings and expected long-term growth. These are typically time-tested companies that are able to consistently produce steady cash flows and revenues throughout time. The value here is determined by the market’s inefficiency to price them justifiably against their performance. In essence, it is a stock that is deemed to be “cheaper” than what it is actually worth.
Characteristics of value stocks
- Value stocks are priced cheaper relative to their earnings and expected growth potential
- Usually arising from business models that can produce steady cash flows in the long term
- They tend to have less fluctuations in prices and risk volatility
Examples of value stocks
- Johnson & Johnson (NYSE:JNJ)
- Sheng Siong Group Ltd (SGX:OV8)
- Procter & Gamble (NYSE:PG)
- Citigroup Inc. (NYSE:C)
What are growth stocks?
Growth stocks are those from companies that have relatively higher valuations than normal as measured by their price-to-earnings or price-to-book value ratio. They tend to have a track record of exceptional gains in earnings within recent years, ones that are higher than the industry average. Think of popular technology stocks such Netflix (NASDAQ: NFLX), Amazon (NASDAQ:AMZN), and Google (NASDAQ:GOOGL) that have redefined the way we live, work and play. These are usually headliner companies that have rallied significant investor fanfare leading to increased valuations.
Characteristics of growth stocks
- Markets ascribe to them higher valuations and investors are willing to pay higher price-to-earnings multiples
- Prioritises faster revenue building over profitability and can sustain recurring earnings
- They also tend to be more volatile and susceptible to short term swings
Examples of growth stocks
- Netflix (NASDAQ: NFLX)
- Amazon (NASDAQ:AMZN)
- Tesla (NASDAQ:TSLA)
- Zoom (NASDAQ:ZM)
How are value and growth stocks different?
Understanding what defines a value or growth stock is more than just about its performance. They also differ in terms of the behaviour of their earnings or the metrics used to measure them. Here is a brief summary to show how these differences stack up.
Why the debate between value and growth now?
Higher inflation now shines spotlight on value
The sharper rise in inflation has brought attention back to value stocks, which tend to outperform during times of higher inflation and tightening rates. Growth stocks, on the other hand, will see a lag in performance.
The valuation of growth stocks are dependent on future expected earnings. Higher interest rates tend to follow after inflation and this would mean the value of the stocks are worth less today. The promised future growth is seen to be worth less today than the cash flows you can get instead in the nearer term with value stocks. Essentially, the onset of higher interest rates reduces the value of a company’s discounted future cash flows, and hence its corresponding value today.
This puts pressure on growth stocks that are inherently dependent on the potential of higher future returns. Netflix’s stock performance this week shows how little patience investors have of growth companies that fail to deliver on their lofty valuations in these times.
The tech-heavy Nasdaq index remains under pressure following Netflix’s subscriber slump, and is down some 14% so far this year (as at April 2022).
Read more: Inflation vs growth: what matters more to investors?
Two common benchmarks, the S&P 500 Growth and Value indexes, help to further reflect this value-growth divergence, with the S&P 500 Growth index down by about 12% since the start of 2022 to 19 April 2022. Constituents of the growth index include Microsoft, Amazon and Tesla, all with declining share prices marking a preferential shift towards value in the medium to long term. Other indicators also point towards a value shift — the iShares Russell 1000 Growth ETF (IWF) and ARK Innovation ETF (ARKK) have also fallen significantly since the start of the year.
Who dares wins
Conventional investing wisdom suggests that growth wins when the market gets greedy, while value is the way to go when investors are fearful. The expectations of higher rewards in the future come along with taking more risks in the short term.
But while growth stocks have indeed enjoyed a better track record in the bull runs of recent years, there is an element of speculation in their valuations, and it is also highly dependent on the market’s confidence in the future outlook. In addition to the rising inflation, the Russian-Ukraine conflict and corresponding geopolitical tensions are a one-two punch to growth, as investors flock to value.
Read more: Russia-Ukraine war: The only certainty now is uncertainty
Beware of value traps and growth hype
That said, we need to also realise that it is too binary to bucket stocks into either-or categories. There are instances where value and growth stocks both fail to live up to their expectations. In some cases, for example, stocks of companies have been priced lower than its fundamentals precisely because of poorer business performance rather than a mispricing, leading to what is known as a value-trap to investors.
On the flip side, too much scepticism in growth stocks is also a shortcoming for singularly value-focused investors that fail to buy into technology companies, missing out on opportunities to buy into players that do indeed have the disruptive potential for long-term success. These opportunities can be overlooked if investors strictly categorise these stocks prematurely.
What should also be noted is that for all the pessimism in the markets right now, major companies are largely reporting better-than-expected results so far. As of 20 April 2022, 8 in 10 of the companies on the S&P 500 index that have reported results topped the profit expectations based off Refinitiv data.
Notably, on the same day that the Netflix stock slumped, Tesla reported record profits for the quarter as it powered through supply chain disruptions thanks to its pricing power — Tesla's shares rose in late trading after the firm posted results that beat expectations.
Many factors impact a security’s valuation, and this is why it is important to exercise your discretion to discern between noise and fundamentals. In the words of the valuation sage Prof. Aswath Damodaran: “Success in investing comes not from being right but from being wrong less often than everyone else”.
History tends to be on value’s side
If history is any guide, value stocks have had higher expected returns over the past few decades. According to research from Dimensional Fund Advisors, value stocks have, on average, outperformed growth stocks by 4.5% annually since 1928.
The outperformance also applied to markets beyond the US, with value leading in terms of the annualised compound returns within the developed and emerging sectors as well.
What does it all mean for investors?
History has favoured value investing, though growth stocks cannot be ignored given that technology is set to touch every aspect of business. A better framework would complement other quantitative rules, or factors, like size and quality, that have also shown to be robust determinants of portfolio returns over time and across different markets.
Decades of academic research have been dedicated to this three-factor model by Nobel Laureate Dr. Fama and his colleague Dr. French, which have shown that there are pervasive and proven factors to drive future returns of asset classes.
Learn more about the Endowus Factor Portfolios by Dimensional, through which you gain systematic and diversified exposure to the long-term proven factors of returns, such as value, size, and profitability in equities, and term and credit in fixed income.
To tap our suite of globally diversified portfolios, get started with Endowus.
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