How well do you know the differences between growth and value investing? Want to determine if one of these strategies is suitable for your investment goals? Let’s explore the principles of value and growth investing as well as the pros and cons of each of these renowned and debated investment strategies.
THE FUNDAMENTALS OF VALUE INVESTING
Studies have shown that value investing has done better over time compared to growth investing.1 But it should come as no surprise that exceptions can occur and under-valued companies aren’t always winners.
What’s the fundamental concept of value investing? The framework was formed in the 1930s by two finance professors at Columbia University, Benjamin Graham and David Dodd.2
The basic idea is for investors to identify and purchase companies that the markets have undervalued. If and when the markets adjust upwards to the true valuation of those companies, value investors can earn profits on those price increases.
Cheap Prices Don’t Necessarily Indicate Good Value
Keep in mind, value investing isn’t about buying every stock that has fallen or is priced low. After all, low share prices can be due to legitimate reasons such as underlying issues with a company’s financial health and prices may remain low if solutions aren’t put in place.
Value investors look for companies with strong fundamentals that the market hasn’t fully reflected in the price. They analyze a company’s intrinsic value by looking at various aspects such as its cash flow, earnings, book value, and business model, looking for clues that the current stock price is undervaluing its full worth.3 A few guidelines that some value investors utilize to select investments include4:
• D / E ratio < 1
• PEG ratio < 1
• Market Cap < Book Value
• Cash > Market Cap
• Current assets at least two times current liabilities
Now let’s take a look at some of the pros and cons of value investing.5
Pros of Value Investing
• Value investors can take advantage of devalued assets when others are panicking.
• The hype and herd mentality do not have much of an effect on a value strategy.
• Day-to-day price fluctuations and market volatility are not much of a concern to value investors because they are focused on the value of a business instead of external factors.
• Value investors can experience steady and consistent gains that may outperform benchmarks such as the S&P 500.
Cons of Value Investing
• Value investors may lose out on larger returns due to searching for companies with a margin of safety.
• The underperformance of a company’s share price could last for years or may never rise to the investor’s estimate of fair value.
• There may be a lack of liquidity due to the stock’s underperformance or low market cap.
• It can be difficult to determine if a stock has bottomed out or could continue falling further down.
• Finding investments can require a lot of time spent on research and analysis.
THE BUILDING BLOCKS OF GROWTH INVESTING
Thomas Rowe Price, the founder of T. Rowe Price Associates, has been dubbed by many as “the father of growth investing.” Price’s growth philosophy was based on investing in companies that he believed would grow faster than the economy and inflation.
Some of the aspects Price looked for included well-paid employees coupled with low labor costs, limited competition, protection from government regulation, earnings per share growth, consistent high profit margins, and a minimum 10% return on invested capital.6
Diamonds In The Rough
Growth investing is typically focused on a company’s potential down the road, and not so much on its current share price. Growth stocks also tend to be younger companies that reinvest their earnings into the company instead of paying dividends and are identified as growing significantly faster than their competition (aka Growth At A Responsible Price). They may also be a part of industries such as technology that are experiencing fast expansion.
Examples of guidelines that some growth investors follow when selecting investments include7:
• Historic earnings growth. For example, a minimum of 7% earnings per share (EPS) growth for companies between $400M – $4B.
• Companies with an expected 10-12% earnings growth rate over the next five years.
• Industry leaders that have beat pre-tax profit margins for five years.
• Steady or rising ROE.
• Expectations that the stock price can double in five years.
Here are some noteworthy pros and cons of growth investing investors should consider8:
Pros of Growth Investing
• Successful investments may appreciate much faster than the overall market by the very definition of growth investing.
• Investment selection is focused on attractive companies with above average earnings and sales growth.
• Investors can gain exposure to cutting edge industries that are rapidly evolving and are exciting to watch.
Cons of Growth Investing
• Higher risk and volatility.
• Dividends are uncommon as most growth companies reinvest their earnings.
• Time intensive to evaluate the credibility of various growth projection estimates.
• Valuations could be much higher than the market average to reflect projected growth that may never materialize.
Two Sides Of The Same Coin
If you don’t find yourself strongly preferring value investing to growth or vice versa, the good news is you don’t have to choose one over the other. Some investors choose to diversify and apply both methods to their portfolio’s stock selection.
Warren Buffet is known for not associating with one specific strategy and stated in his 1992 Chairman’s letter, “…the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid?”9
TAKING A GARP APPROACH
A blended investment approach such as Growth at a Reasonable Price (GARP) is one way to obtain exposure to the benefits of both growth and value investing.10 The image below visualizes how a GARP strategy can fit in between the typical growth and value investing approaches.
GARP is a well-known investment strategy that looks for companies with low Price Earnings to Growth (PEG) ratios. PEG helps investors to identify companies with high earnings growth rates compared to their price-earnings (P/E) multiples. The idea is that companies with these characteristics may be inexpensive relative to their historical earnings growth rates, making them a potentially attractive investment opportunity.
Do you prefer value versus growth investing or a blended approach? Have your investment style and preferences changed over time? Please share your thoughts in the comments below.
Photo Credit: https://www.flickr.com/photos/unitedsoybean/9632910180
3 Investopedia, http://www.investopedia.com/terms/i/intrinsicvalue.asp
4 Investopedia, http://www.investopedia.com/university/stockpicking/stockpicking3.asp
5 FT Advisor, http://www.ftadviser.com/2013/08/12/investments/global/pros-and-cons-of-value-investing-Cb3lW5fpwbrR4WcZQLEVrO/article.html; Wikinvest, http://www.wikinvest.com/concept/Value_Investing
6 Investopedia, http://www.investopedia.com/university/greatest/thomasroweprice.asp
7 Investopedia, http://www.investopedia.com/university/stockpicking/stockpicking4.asp
8 Investopedia, http://www.investopedia.com/university/stockpicking/stockpicking4.asp
9 Gurufocus, http://www.gurufocus.com/news/226616/warren-buffett-on-value–growth-the-two-approaches-are-joined-at-the-hip
10 Investopedia, http://www.investopedia.com/terms/g/growthinvesting.asp