By just about every metric, 2022 was a terrible year for growth stocks but a solid one for value stocks.
The Dow Jones Industrial Average outperformed the Nasdaq Composite by the largest margin in over 20 years. Ark Innovation ETF, Cathie Wood's exchange-traded fund, lost 67% of its value in 2022, while Warren Buffett's Berkshire Hathaway gained 4%. And the Vanguard Growth ETF lost 34% of its value last year, while the Vanguard Value ETF fell just 5%.
One of the million-dollar questions of 2023 is whether value stocks can continue outperforming growth stocks. But instead of speculating on short-term trends, there are better questions to ask: What role do you want growth stocks to play in your portfolio? Are they right for you in the first place? If so, what kind of growth stocks give you the best chance to reach your financial goals while aligning your investments with your personal risk tolerance?
We'll discuss these questions and more in this article.
Image source: Getty Images.
Lessons from 2022
2022 was the worst year for the stock market since 2008 and the worst year in many investors' lifetimes. Yet bear markets can help lead you toward lasting wealth as long as you're invested in quality businesses, hold through volatile periods, and continue to save regularly.
Last year illustrated the dangers of gambling instead of investing. Many unprofitable growth stocks and meme stocks saw their valuations balloon to nosebleed levels that could no longer be supported by their fundamentals. Once the dust settled, it was clear that many of these companies simply weren't worth that much, at least not today.
Like the dot-com bust, some notable companies will emerge from the ashes and eclipse their prior all-time highs over time, but it could be many years before those stocks reverse the losses from this bear market. It took Microsoft (NASDAQ: MSFT) over 17 years to finally surpass its 1999 all-time high. And it did so by unlocking new revenue streams, reinventing its business, and becoming an industry leader in several key categories.
Investors looking at growth stocks that are down 70%, 80%, or 90% from their all-time highs shouldn't buy them solely because they are down. Rather, investing only in companies you understand and believe can foster long-term value is important. Just because a company is exciting and growing doesn't mean the stock is a good buy. For a growth stock to continue outperforming the market over time, a rising stock price has to be supported by the fundamentals.
Growth stocks at a good value
When a company's fundamentals keep pace or even exceed its stock price, a growth stock can start to look much more like a value stock. That's exactly what's happening to Microsoft, Apple (NASDAQ: AAPL), and Alphabet(NASDAQ: GOOG)(NASDAQ: GOOGL) right now.
All three stocks have beaten the market over the last five to 10 years. But their recent sell-offs, paired with incredible revenue and profit growth, have compressed the price-to-earnings (P/E) and price-to-free-cash-flow (P/FCF) multiples.
Data by YCharts.
The P/E ratio of the S&P 500 is 19.9 as of this writing, meaning Alphabet now trades at a discount to the market. Apple sports a similar multiple, while Microsoft trades at a slight premium.
Meanwhile, Amazon(NASDAQ: AMZN) may not have consistent profitability or FCF, but the stock is now trading around a 10-year low on a price-to-sales (P/S) and price-to-operating-cash-flow (P/OCF) basis.
I mention these four companies, because they are the largest components of the Nasdaq Composite and tend to be the largest holdings in growth ETFs like the aforementioned Vanguard Growth ETF (the largest growth ETF by net assets). Yet these growth stocks differ wildly from smaller-cap, unprofitable growth names valued at what they could become instead of what they are today.
Foundational growth stocks that are built to last
For most investors, the attractive valuations, wide moats, rock-solid fundamentals, and growth prospects of mega-cap names like Microsoft, Apple, Alphabet, and Amazon stand out right now as compelling risk/reward opportunities that also help you sleep well at night. After all, even Berkshire Hathaway, which normally doesn't invest in growth stocks, recognized the attractive valuation of Apple, and it's now the conglomerate's largest holding today.
For risk-tolerant investors with a long-term horizon, now also could be an excellent time to selectively choose smaller growth stocks, using money you can afford to lose and don't need anytime soon.
It's no secret the biggest gains in the stock market are made by investing in a company early and watching its value compound over time. But to do that, you want to take the pressure off by not making any single position too large and by maintaining a diversified portfolio that avoids the all-or-nothing nature of being invested too heavily in a single stock or sector.
Growth stocks could very well be in for more pain in 2023. And many growth stocks could fail, or at the very least, fail to surpass their highs from 2020 and 2021. Instead of worrying about whether your favorite growth stocks will beat the market this year, a more rewarding endeavor is to follow the business, make sure the investment thesis stays on track, and properly weigh your holdings in a way that suits your risk tolerance.
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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Daniel Foelber has positions in Alphabet and Amazon.com and has the following options: long January 2025 $170 calls on Amazon.com, long January 2025 $90 calls on Amazon.com, short February 2023 $100 calls on Amazon.com, and short January 2025 $175 calls on Amazon.com. The Motley Fool has positions in and recommends Alphabet, Amazon.com, Apple, Microsoft, Vanguard Index Funds - Vanguard Growth ETF, and Vanguard Index Funds - Vanguard Value ETF. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.
