Growth vs. Value: What to Buy?

By Ian Wyatt

Most people tend to think that small-cap stocks are all growth companies. The prevailing wisdom is that if a company has a market cap below $3 billion, then the reason to buy shares is that the company has tons of room to grow and perhaps eventually become a large-cap stock, and in the process earn early investors multiples on their initial investment.

But this perspective doesn't show the entire picture. There are tons of small-cap value stocks out there, and many of these companies don't ever expect to grow to be true large-caps. Maybe they see their future as a mid-cap company some day, but in the meantime they are focused on consistent performance, and paying dividends to shareholders.

It's relatively easy to dissect small-cap performance these days by looking at ETFs. Doing so allows us to determine whether it's better to buy small-cap value right now, or whether small-cap growth should earn your dollars.

The 10-year chart below shows the price performance of the iShares Russell 2000 ETF ( IMW). The ETF tracks the entire underlying index and is a blend of both value and growth. As you can see it is just about back to its 2007 high around 80.

Under this I've plotted the performance of the iShares Russell 2000 Growth ETF ( IWO) and the iShares Russell 2000 Value ETF ( IWN).

According to these ETFs, small-cap value has outperformed small-cap growth over the past 10 years by a wide margin -- more than 50 percent in fact.

That outperformance is compelling evidence that small-cap value is the way to go. And for part of your portfolio, it absolutely is. Data from Ibbotson shows that between 1926 and 2004 small-cap value stocks posted a 15.9 percent annual return. That's impressive performance, the trumps growth stocks of any market cap. Here are two small cap value stocks with huge potential.

But don't go selling all of your growth stocks and piling into value right now. My point in juxtaposing these ETFs is to get you thinking about how to allocate between growth and value at different times -- not to say ditch one and go with the other. You should buy and hold both over the long-term.

Consider the impressive returns over the past 10 years of the following five growth stocks: Hansen Natural ( HANS), 10,930 percent; Clean Harbors ( CLH), 4,210 percent; Southwestern Energy ( SWN), 3,273 percent; Green Mountain Coffee Roasters ( GMCR), 2,070 percent; and Bally Technologies (NYSE: BYI) - 1,560 percent

Anybody that invested $10,000 split evenly among the above companies ten years ago would have earned 44 times on their original investment, for a total of over $440,000.

Granted, that superior stock picking record would be absolutely amazing but the point is that even getting one of these companies right would lead to huge returns that would overshadow even a total loss in the remaining four companies.

That's the power of investing in growth stocks.

One major caveat to looking too closely at ETFs tracking small-cap index returns lies in the turnover of the underlying index. Growth stocks tend to be more volatile, and that means if they plummet (like in the last two recessions) they could get bounced from the underlying small-cap index.

This doesn't help returns, because these stocks will never have a chance to recover their gains. Also, many of the weakest companies won't make the index until they have already posted huge gains, so the index misses out there too.

Conversely, when small-cap growth shines, some stocks will outgrow the small-cap constraint, so they need to be removed. That means some of the best performing small-cap growth stocks are not calculated in the index returns.

Russell Investments has a clear summary of their index construction methodology here .

So let's return to the origin of this article: Should you buy growth or value right now?

The answer is both. This isn't a cop-out, by the way. If one was truly better than the other, I would say so. You should be buying both, consistently and steadily to take advantage of the best performing asset class over the long term.

Until tomorrow,

Ian Wyatt, editor of SmallCapInvestor.comDisclosure: NONE

Wyatt Investment Research, founded in 2001 as a publisher of newsletters, offers independent investment research of financial markets, stocks, bonds, ETFs and mutual funds to about 250,000 individual investors. The company is led by founder Ian Wyatt, who serves as publisher and chief investment strategist.

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