Should I Only Invest in U.S. Large Growth Companies? Part 2: The Value of Not Neglecting Value Stocks

As we discussed in Part 1 of this post, we at PFS advocate holding diverse stock portfolios—including growth and value stocks, large and small company stocks, U.S. and international stocks.  The distinction between large and small as well as U.S. and international stocks is fairly straightforward and easy to understand.  Many investors, however, are not familiar with the difference between growth and value stocks.  Appreciating the difference (and investing on both sides of the spectrum) could positively impact your portfolio’s volatility and long-term returns.  It could also make you think twice before jumping on the bandwagon of certain U.S. large growth companies, whose prices have skyrocketed in recent years.

Comparing Growth and Value Stocks.  In discussions with clients, we often describe value stocks as belonging to companies that have fallen out of favor or are not in their prime (right now, e.g., oil companies and airlines are a good example).  However, many value stocks are simply companies from which investors don’t expect much growth, but they do expect slow and steady profits (e.g. utilities, car manufacturers).  For example, Toyota would be a value stock, while Tesla would be a growth stock.  Investors expect more future growth out of Tesla.  They expect Toyota to continue selling a lot of cars and making a profit but do not anticipate significant future growth.  In terms of financials, value companies often pay higher dividends (whereas growth companies reinvest more of their profits into the company), and value companies have a comparatively low price-to-earnings ratio.  In other words, the price of the stock is low relative to the amount of earnings that the company has generated in the past year. 

Why Invest in Value Stocks?  Proponents of value stocks argue that value investing just makes logical sense:  if you pay a lower price for something relative to what it’s worth, you can expect higher returns in the future.  Importantly, value stocks also have a strong track record over the long-term.  From 1928 to 2019, value stocks have outperformed growth stocks by over 4 percent annually on average in the United States.  As we demonstrated in Part 1 of this post with respect to small company stocks, there are significant periods of time in which value stocks outperform growth stocks, which is the practical rationale for holding value stocks.  (The same can be said of investing in international stocks versus U.S. stocks, as we discussed in a blog post a few years ago.)

What Does This Mean for Prices of Growth Stocks?  As mentioned above, one piece of information that financial analysts use in determining whether stocks should be considered growth or value is the stock’s price-to-earnings (PE) ratio.  Evaluating PE ratios also may give investors pause right now about investing in particular stocks, including some of the U.S. large growth companies whose prices have soared in recent years.  Returning to the example of Toyota versus Tesla, Toyota currently has a PE ratio of around 8, whereas Tesla has a PE ratio of 1,099.  Therefore, the price of Toyota assumes that the company is worth 8 times the amount of its annual earnings, while the price of Tesla assumes that it’s worth 1,099 times the amount of its annual earnings.  Is Tesla worth that much?  Will it grow enough in the future to merit such optimism?  Perhaps.  But investors have good reason to buy up the Toyotas of the market too, just in case the Teslas of the market don’t live up to the lofty expectations built into their current stock prices.