Investment portfolios need growth and value

Growth stocks are like pitchers who won 20 games last year. If you want to buy them for your team, you’ll have to pay up. But they may win 20 games again this year — or even more. So they can be worth it. A wonderful example of a growth stock: Google.

Value stocks are pitchers who won 20 games the year before last. Last year, they hurt their arms and their record was 4-9. So, if you want to buy these pitchers for your team, you’ll get them for a song. And if their arms heal and they win 20 games again, you will have hit the jackpot.

A better metaphor may be a horse race. Growth stocks are the favorites. They pay 3 to 2. So even if they come in first, you won’t make a fortune. Value stocks are dark horses with odds of 15-1. You’ll clean up if they win, place or show.

Essentially, growth stocks have relatively high price-earnings ratios and relatively high price-book ratios. Value (short for “undervalued”) stocks seem to be cheap. They have low p-e and low price-book ratios. Some investors buy growth stocks, others buy value. Others buy both.One of the few incontrovertible facts about investing is: Over the years, value beats growth.

How come?

* Many value stocks pay dividends, and dividends always have played a big role in the appreciation of stocks.

* When bad news hits, growth stocks fall from the roof. Value stocks are already at ground level, so they don’t fall as far.

* Growth stocks tend to become extremely overvalued — impossibly, ridiculously overvalued — as amateur investors buy whatever has been hot.

* Value stocks tend to become extremely undervalued. Investors sell them (or avoid them) because they believe that whatever has been cold will remain cold, if not turn frigid. It’s not easy to give a “wonderful” example of a value stock because — who knows? — it may turn out to be a dog, well worth avoiding. But how about Altria (Philip Morris)?

* Growth stocks also go to extremes because investors don’t want to sell them and pay capital-gains taxes. Value stocks go to extremes because investors are eager to sell them to lock in taxable losses.

Naturally, value stocks and growth stocks tend to perform differently at different times. Value stocks have been doing so well lately that lots of smart people are predicting — as they have for a long, long time — that growth stocks and funds will finally start outperforming value stocks and value funds, and they probably are right. This just means you should maintain some exposure to growth. But in general tilt toward value, especially as you get older.

Now, Warren Buffett — you’ve heard of him? — has said that growth and value are connected at the hip. There’s some truth to that. But winter and summer are connected by spring and fall; night and day are connected by dawn and twilight. And growth and value investors are even more different than you might suspect.

* They make different kinds of mistakes. Growth investors buy too late (the stock has already soared) and sell too late (the stock has already fallen to China). Value investors buy too soon (the stock has further to fall) and sell too soon.

* Value investors hold onto their stocks longer. They are patiently waiting for other investors to come to their senses and recognize quality.

* Because of their higher turnover, large growth funds have higher expenses.

* Growth funds are more volatile. Their average standard deviation (a measure of volatility) recently was 10.87. The standard deviation of large value funds was only 8.47.

Warren Boroson covers financial news for the Daily Record of Morris County, N.J. His column appears Thursdays in The Journal.

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