How Academic Finance Distinguishes Value and Growth Stocks

# Clarifying the Fundamental Difference Between Growth and Value Stocks


# Clarifying the Fundamental Difference Between Growth and Value Stocks












The more I think about the fundamental difference between growth and value stocks the more confused I am. Both strategies seem to exploit market mispricing: growth investors target underestimated future growth, while value investors focus on undervalued current fundamentals, yet in the end it both boils down to supposed misjudgments of future return rates by the market.

Beyond metrics like P/E ratios and earnings growth, what are the core principles that fundamentally differentiate growth and value investing? Are there specific strategies, risk profiles, or psychological aspects that set them apart? Or is this just some arbitrary differentiation that doesn't make real sense on the fundamental level:

Any insights, references, or pointers would be greatly appreciated. Thank you!

## Answer by Kevin (score 4, accepted)

https://quant.stackexchange.com/a/79922

An interesting question and the answer likely varies between what people label "growth" and "value". I fear some (a lot) of that is pure marketing.

In academic finance, we typically think of valuation ratios as distinguishing criterion between value and growth stocks. Value stocks have a high book/price ratio, growth stocks have a low book/price ratio. While academics like book-to-market as a characteristic (in large parts due to Fama and French), other variables work fine too: earnings/price, sales/price, dividends/price, ...

Ultimately, value stocks are cheap stocks. Their fundamentals are high relative to their traded price - typically because they are poor performing, distressed stocks. Growth stocks are expensive stocks of higher quality. Funnily enough, Fama himself said he doesn't like the terms "value" and "growth". His former PhD student, AQR's Cliff Asness, echoes that and prefers the terms "cheap" and "expensive".

Historically, cheap stocks outperformed expensive stocks ("value premium") which aligns with the value investing of Benjamin Graham. Kind of makes sense. High prices mean low expected returns. There are plenty of sophisticated explanations for why value stocks have historically outperformed growth stocks, both behavioural and risk-based, and more recent theories why this premium may change over time.

However, if you look at the best performing stocks (the Microsofts in this world), they are all expensive stocks. So the picture is like this: on average, value stocks outperform growth stocks, but the absolute winners are hiding somewhere amongst the generally poor performing expensive stocks. Some trading firms would like to identify these superstar firms and pursue a growth strategy as a result.

More recently, some factor models include an expected growth factor which refers to firms which are likely to invest in the future. While high past investment predicts lower average returns, high expected investment actually predicts higher average returns. However, measuring expected investment is tricky, of course.