Investors tend to categorise stocks by the trading opportunity provided:

•    Growth stocks are those with earnings expected to grow at a higher rate than the overall market, generally measured as a 15% or higher return on equity. Sometimes called “glamour” stocks, they demonstrate high ratios of profitability, and are often found in the technology or health care sectors. Growth stocks tend to trade at a premium to the market and may seem overvalued when filtered through many screens such as price to earnings or price to book ratios.

•    Value stocks, on the other hand, are stocks that are undervalued by the wider stock market and trade at a discount when filtered through those same screens. This category includes some stocks in the financial or consumer staples sectors. Value stocks tend to demonstrate a high dividend yield as well as low price to earnings or price to book ratios.

Value-oriented investors historically preferred to purchase undervalued or “fire sale” stocks and hold them until their values rise. However, more recently, investors including Warren Buffett have lauded a new and widely publicised concept of “finding an outstanding company at a sensible price” when value trading.

Some years growth stocks perform best, but mainly value stocks outperform. The years that have favoured growth over value include 2007, 1995–99, 1989–91, 1987, 1985, and 1982. Note that this tendency is only partially correlated to the underlying business cycle.

This is important for traders because it’s always difficult to successfully trade when out of step with the market. Thankfully it’s relatively simple to determine which category is providing superior performance throughout the year, as several websites offer growth versus value comparison charts. The best known of these websites is Russell.com, which further subdivides some its many regional and market capitalisation indices between growth and value, thus providing traders with an easy reference.

The chart below compares the Russell indices for developed Pacific Basin nations, excluding Japan, across value and growth sectors.

index    month to date July 2010    year to date 2010    1 year
Russell Dev. Pacific Basin ex-Japan growth    5.3    −6.1    25.9
Russell Dev. Pacific Basin ex-Japan value    5.2    −5.1    26.9

Note how both indices are in the red year to date, although showing positive stock growth over the month-to-date and one-year horizons. From a traditional investor’s buy-and-hold perspective, it appears that value is outperforming, not having seen such a large fall in the year to date.

However, for technical traders it shows that growth stocks are seeing more active price movement and therefore greater opportunities. Traders searching for long or short prospects may wish to keep this in mind while designing their current filters.

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