This post is an excerpt from Wells Fargo Investment Institute’s “Ask the Institute” series.

Key Takeaways

  • A growth stock’s total return is more likely to come from capital appreciation than dividend income; a greater proportion of a value stock’s performance is likely to come from dividend income.
  • Long-term investors don’t have to choose between growth and value and, in many cases, they may benefit from a combination of the two styles.
  • Shorter-term (cyclical and tactical) opportunities to reallocate to growth vs. value, and vice versa, may sometimes arise.

Growth and value in brief


blog-20161003-chart1Growth companies are typically associated with companies that are increasing revenue or earnings faster than the average company for their respective industry or the overall market. While many growth companies are younger and still expanding, there are mature companies that can be classified as growth-oriented when they experience growth from a new product cycle or favorable market, economic, or policy conditions. Although sectors do not normally fit perfectly into growth or value styles, some that lean in the growth direction are Technology and Health Care.

 

blog-20161003-chart2Value companies have been traditionally characterized as having higher dividends and cheaper valuations. In some cases they are considered “unloved stocks.” Value is sometimes mistaken for just low-quality, out-of-favor stocks. We view value investing as reaching an investment decision by looking at the underlying value of the business and finding stocks trading for less than their intrinsic value. Two sectors that often lean in the value direction are Financial Services and Utilities.

Total Return Composition Differs Between Styles

Looking at a stock’s total return, determined simply by adding any capital appreciation together with any dividends, can be helpful in understanding the difference between a growth and a value stock.

Growth companies usually reinvest profits back into the business to help fund expansion and, therefore, pay little or no dividends. As a result, a growth investor would expect the lion’s share of his or her total return to come from any capital appreciation:

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Value companies, on the other hand, tend to be more established and, for one reason or another, are trading for less than their intrinsic value. Because they may have been around for a while, these companies are more likely to pay a dividend, so an investor would expect dividends to provide a greater portion of his or her total return:

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As the chart below shows, growth investors have been willing to accept a greater portion of their total returns in the form of (sometimes irregular) capital gains while value investors have usually received a greater share of their returns from (typically more regular) dividend payments.

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Is the Difference Important Over the Long Term?

In his 1992 Berkshire Hathaway shareholder letter, Warren Buffet had this to say about growth vs. value:

“In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”

After choosing to include stocks in a portfolio, an investor may consider several types of stocks. Global stocks can be classified in a variety of ways. At the highest level, they are typically defined by market capitalization and style (growth or value). Further classifications can include economic sector, industry, and dividend yield, to name just a few.

While our sector views may at times imply a bias toward growth or value, our view is that investors don’t have to choose between one style or the other and, in many cases, they may benefit from a combination of the two. Value- and growth-oriented investments have had periods of wide dispersion—2015 was a prime example as growth stocks handily outperformed value, while in 2016, value has outperformed growth.

Many indexes combine growth and value stocks. This strategy, called “blend” or “core,” can exhibit characteristics of both styles of investing. Additionally, growth stocks can become value stocks, and vice-versa, so funds that delineate between the two may trade more frequently than a blend or core fund.

Even over longer periods, as shown in the chart below, value and growth alternate as performance leaders without one consistently overperforming the other.

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The table below shows growth and value exhibit high correlations to the core index, which suggests that there is little to no benefit over the strategic time period to classify as distinct strategic asset classes. Correlation is a statistical measure that describes the degree of association between two asset classes. Positively correlated investments tend to move in the same direction, while the opposite is true of negatively correlated investments. The closer a number in the table is to 1, the greater is the correlation.

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The Story Can Change for the Short Term

blog-20161003-chart8While we do not see a benefit in splitting equity allocations into growth and value styles over a strategic (10-15 year) time horizon, we believe tactical (6-18 months) and cyclical (3-5 years) opportunities sometimes exist in these categories. Our central methodology for rating growth and value styles includes:

  • Beginning with in-depth, long-term studies of economic changes over time
  • Comparing the relationship of economic changes to the relative performance of growth and value stocks in the following period
  • Using the relationships identified above and the most recent one-year changes in the key economic factors to estimate the attractiveness of one style vs. the other
  • Using favorable, neutral, and unfavorable ratings to reflect the relative level of attraction toward a specific style (relative to the S&P 500 Index, which represents a blend of both styles)

Risk Considerations

Investments are subject to market risk which means that their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, industry sectors, and potential risks that may be inherent to the companies’ sizes. There are no guarantees related to future performance for the security categories referred to in this commentary, be they growth, value, dividend, or international securities.

For a complete list of indexes, please visit this page.

Wells Fargo Investment Institute, Inc.  is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A. and other Wells Fargo & Company affiliates.

© 2016 Wells Fargo Investment Institute. All rights reserved.

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