First off, picking individual stocks isn’t for everyone — most new investors are well-served by a simple portfolio of mutual funds and exchange-traded funds.
Finding the right stock to buy in the market can feel like searching for a needle in a haystack. It’s easy to be overwhelmed with jargon and a deluge of statistics, ratios and charts. How do you determine if a stock meets your criteria?
Like many new investors, you may end up picking the wrong stock — or throwing up your hands in frustration saying “Only an analyst could possibly know what they’re doing without getting into trouble, right?”
Maybe not. Choosing stocks is actually easier than it seems.
Think of the stock market like a retail store: some products are so popular they fly right off the shelves at full price. Other items get marked down until they sell. In the stock market, popular stocks sold at a premium price are known as growth stocks. Stocks that are “on sale” are called value stocks. Both kinds may have a place in your portfolio; each has strengths and weaknesses. Let’s look at growth stocks vs value stocks and the pros and cons of each.
Growth stocks belong to companies on the rise. They can range in size from just a few hundred million in market capitalization up to many billions. These companies are projected to grow earnings at a greater-than-anticipated rate and are thus priced higher due to the increased expectations.
Growth stocks may pay little — if any — dividends because they’re reinvesting profits into the business itself. Most technology companies fall into this category, but growth stocks can be found in every industry. They will show a high P/E (price-to-earnings) ratio which represents how much investors are willing to pay for future earnings. They are often volatile investments and the first ones to decline on poor economic news.
Value stocks are touted as companies on sale. These can include unpopular sectors like manufacturing during recessionary times or companies with sound business models but recent troubles, such as missed earnings.
Value investors can buy stocks at significant discounts by buying a stock while everybody else is waiting for the turnaround. Value can be found in every sector and can be any business but they all have a few commonalities. They usually pay a dividend and have low P/E ratios, representing investors’ unwillingness to pay much for an unpopular stock.
You can get a better picture of what growth and value stocks look like by using a free fund tool like Morningstar and looking at what a mutual fund specializing in these categories owns. As an example, let’s take a look at the T. Rowe Price Large Cap Growth Fund (TRLGX).
We can see the top three stocks held in the fund:
- Google (GOOG)
- Amazon (AMZN)
- Gilead Sciences (GILD)
If you keep browsing, you’ll see a lot of familiar names on the list like Boeing (BA), Starbucks (SBUX), and eBay (EBAY). You can narrow down your search by checking out mutual funds with names like mid-cap value, or small cap growth to give you a listing of these stocks by size as well.
By contrast, look at the T. Rowe Price Value Advantage Fund (PAVLX). It’s top three holdings are:
- JP Morgan Chase (JPM)
- Pfizer (PFE)
- Merck & Co. (MRK)
Again, value stocks can include big brands — just ones that are selling at a discount at the moment because of economic cycles or business hiccups.
Although growth and value stocks are the bread and butter of any investment portfolio, they do have some risks associated with them.
Growth stocks may have a higher premium, as represented by its P/E, than should be warranted. Investors could end up paying too much for a stock that never delivers.
Value stocks may be cheap, but some are cheap for a reason and never recover. These types of stocks are known as value traps. It’s not always easy to differentiate between companies that are healthy with a short-term problem and those whose problems may be long term. If you can, however, you’re on your way to a lifetime of healthy returns!