How to Trade Growth vs. Value with ETFs

Ever been to an investment conference or watched CNBC? If so, you’ve heard people talk about “growth stocks” and “value stocks.”

What do they mean by this? How does knowing the difference make money for you? Today I’ll tell you what these terms mean and give you some ways to take advantage of them with exchange traded funds (ETFs).

Two Kinds of Stocks —
Two Kinds of Investors

If you want to buy stocks, you can take your pick of thousands. Each has its own character and history. The most successful investors have a “style” and stick with it. This isn’t a matter of right or wrong; it’s all about finding a match for their personal preferences and philosophy. They stick with what works for them.

Broadly speaking, investors want to see either growth or value in the stocks they pick. What’s the difference?

Growth investors like to see the numbers headed up.

Growth investors buy companies that they believe are growing faster than the market. How do you measure this? Take your pick of many different statistics: Earnings, sales, book value, etc.

The growth investor doesn’t especially mind if a stock’s share price has already gone way up. He thinks it’s heading even higher in the near future. And he wants to get on the train, even if it’s already moving.

Value investors, on the other hand, are looking for bargains. They want to find unknown little companies — or unpopular big ones — that are being shunned by the market. The cheaper, the better!

Value investors like bargains.

When the value investor looks at a stock, he tries to measure intrinsic value. If he calculates that a company’s assets are worth, say, $100 per share and the shares are trading at only $50, he sees a chance to double his money. Value investors tend to be very patient … they don’t mind waiting a long time if the discount is big enough.

Breaking It Down By Size …

Remember, every stock is typically either growth or value. Some analysts, however, add a third category, called “blend,” for stocks that fall somewhere in the middle.

Another thing to keep in mind is that stocks can change over long periods of time. A sleeping “value” stock of the 1990s may very well be a “growth” stock this decade.

You can drill down a little further by separating stocks into size categories, usually by their market capitalization — small, mid or large. This is simply the total worth the market assigns to a company. It’s easy to calculate, too. Just multiply the current share price times the number of shares outstanding.

Do this and instead of two categories you’ll have six …

• Large Cap Value

• Large Cap Growth

• Mid Cap Value

• Mid Cap Growth

• Small Cap Value

• Small Cap Growth

Professional equity portfolio managers tend to specialize in only one of these categories, just as physicians specialize in different parts of the body. You can’t be an expert in everything.

Growth, Value, and Rotation …

Here’s where it starts to get more interesting: The different style categories tend to fall in and out of favor at different times.

That’s because there’s some evidence that small cap and growth stocks perform best when the economy is booming, while large cap and value are better in a recession. This isn’t always the case, though …

For instance, right now we’re in a recession, and growth stocks have been outpacing value stocks for the past three years!

The relative strength of growth and value stocks go up and down at different times.

My experience is that leadership does rotate through the style categories, but the economic patterns are not as reliable as some people think. I find it’s better to look at the actual results of the more recent past.

Rotating Through the
Styles With ETFs …

As I said earlier, every stock falls into one of the style groups. And there are a variety of indexes that keep track of these for you, which are a cinch to follow with ETFs.

Suppose, for example, that you think large cap growth stocks are the best place to invest. You can quickly swing into action with iShares Russell Large Cap Growth (IWF), SPDR Dow Jones Large Cap Growth (ELG), or PowerShares Dynamic Large Cap Growth (PWB).

Then, when you think this category is ready to roll over and investors will move to another style, like small cap value, you could rotate your portfolio to Vanguard Small Cap Value (VBR) or iShares S&P Small Cap 600 (IJR).

These are just examples — I’m not recommending any of them right now. The point is to illustrate the rotation that’s going on all the time under the surface.

There are many ETF families offering style-based products using various index providers. The most popular ones are the iShares ETFs based on the Russell indexes. Two other investor favorites include the funds from Vanguard based on MSCI indexes and another series from iShares that use S&P indexes.

With style-based ETFs, you can follow market strength with much more precision than is possible in broad-market funds.

The bottom line: Where there’s movement, there’s opportunity for profit. Do your homework, and you may be able to find it.

Best wishes,

Ron

P.S. I’m now on Twitter. Please follow me at http://www.twitter.com/ron_rowland for frequent updates, personal insights and observations about the world of ETFs.

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