Investing in equities can be like managing a football team – you can’t just pick all the most up-and-coming, expensive players. It’s better to include some players who are perhaps past the peak of their international careers and hence a bit of a bargain, but are still likely to be solid and reliable members of the team for several years to come.
Carefully selected value stocks work for a portfolio in a similar way. Growth stocks, on the other hand, are the potential stars of the future. Like promising young footballers, they have a bit of work to do in the coming years and lots of room for development. They are more risky, though, because they could get injured before their large transfer fee pays off. But they also have the potential to take the team to the next level.
Managers will want a team with both types of player. But late in the game they might wish to switch towards the value players – those with a bit more experience – which can pay dividends when the pressure is on.
Several metrics are used to characterise a stock as value or growth, such as the price-to book (P/B) ratio, 12-month forward price-to-earnings (P/E) ratio, dividend yield, and short and long-term earnings and sales growth. Value stocks – the steady players – have a lower P/B, a lower P/E and a higher dividend yield than the market average.
Growth indices are often highly skewed towards technology stocks. Information technology currently has a weight of 33% in the Russell 1000 Growth Index. It is no surprise that the growth style has performed particularly well when investors have been excited by the potential returns from rapid technological innovation, such as during the 1990s tech boom.
By contrast, the Russell 1000 Growth Index underperformed through the stock market expansion of the 2000s, which was focused on housing, finance and commodities, rather than technological innovation.
The composition of the value index has changed more significantly through time. At present, the Russell 1000 Value Index is dominated by the financials sector, which makes up 22% of the index. Healthcare is the second-largest sector weighting in the value index, while consumer discretionary is the second-largest in the growth index, behind technology.
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