This survey to determine your investing style and risk temperament (available here) should give you a good idea if you are an aggressive, conservative or more moderate investor, as dictated by the amount of risk you can tolerate. And, for most investors, your current age will also play a part in forming your investment strategy.
Now that you’ve got a handle on your personal investing style, let’s begin our discussion of the various investment strategies—starting with Growth and Value—that will inform your individual investment selections.
Both Growth and Value investors focus on capital appreciation. But how they go about it is very different.
Growth Investing: A growth stock is a stock whose earnings are expected to outpace the market average, or, often, companies that are not yet profitable, but are seeing tremendous revenue increases. Earnings growth (or the expectation of earnings growth) is the biggest determinant of stock price appreciation. Consequently, companies whose earnings are growing—or anticipated to grow at a fast pace, all other market and economic factors being equal—should also enjoy above-market returns on their share prices.
The average annual market gain for the S&P 500 Index (an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ) is 9.8% over the past 90 years. Therefore, a growth stock would be expected to enjoy higher returns than the market average.
Examples of growth investments may include smaller companies that have high potential for growth such as start-ups, cutting-edge technology firms, biotech businesses with promising new drugs, emerging market stocks of less-developed countries, and companies that—for one reason or another—have fallen on hard times, but are now ‘turning around’.
Legendary growth investors included Thomas Rowe Price, Jr., often called ‘the father of growth investing’ due to his comprehensive research on growth stocks, and Philip Fisher, author of the 1958 book, “Common Stocks and Uncommon Profits”.
As those two gurus would confirm, growth investments can be extremely profitable. For example, a $100 investment in Apple (AAPL) stock in 2002 would have been worth $10,656.24 by mid-2018. Likewise, if you bought shares of Facebook (FB) in 2012, you would be sitting on a 223% gain right now. And a 1992 investment in Starbucks (SBUX) would have given you a 16,736% return!
And while that sounds phenomenal—who wouldn’t want to invest in growth stocks?—that’s not the whole story. High-flying stocks also come with some big risks. After all, my mother always said, “what comes up, must come down”, and she was mostly right.
Because growth stocks typically trade at a higher premium (due to demand), those lofty valuations tend to be volatile, and are much more susceptible to rapid declines than their value peers.
Consequently, while a growth investor can reap amazing rewards, be prepared to ride out some wild swings if you are a dedicated growth investor.
I’ll discuss analysis and valuation in more detail in another chapter, but for right now, here are the four primary characteristics that interest most growth investors:
- Robust historic and forecasted growth rate, usually 10% or more.
- Strong Return on Equity (ROE, or net income divided by shareholder’s equity). Compare the company’s ROE with it five-year average as well as the ROE of its industry.
- Solid advances in earnings per share (EPS) or revenues, in the case of newer companies that have not yet posted profits. A subset of EPS is the pre-tax profit margin, which should surpass the industry average and the company’s five-year average.
- Analysts’ estimated future stock price should indicate growth at least in the double digits, but true growth investors often look for a double in five years.
One more caveat to growth stocks. The higher growth companies do not usually pay dividends, or if they do, they generally have dividend yields less than 2%. (A dividend yield is the annual dividend paid to shareholders divided by the share price). That’s because growth companies usually reinvest their earnings in order to accelerate their growth over a short-time period.
On the other hand, Value investors believe that the market is efficient, that stocks reflect all there is to know about that company, meaning they are always priced at their true value. That’s called the efficient-market hypothesis. But successful value investors like Warren Buffett, chairman of Berkshire Hathaway, have disproved that concept many times over. They know that occasionally stocks are underpriced or overpriced relative to their true value, providing investors with great opportunities to ‘buy low’.
Value investors seek these undervalued stocks, or shares that trade for less than their intrinsic values. They believe that stocks move sometimes, simply due to overreactions to good and bad news (or investor irrationality), and not because of their inherent fundamentals.
For example, an earnings report that is perceived by the market to be less than expected can cause a solid, fundamentally strong company’s shares to plummet—many times, temporarily. And a company that beats analysts’ earnings estimates can also decline, if revenues or forward guidance didn’t meet expectations. For example, PayPal (PYPL) saw that happen when the company posted double-digit rises in both income and revenues, but nudged its forward guidance down a little bit. Those movements provide opportunities to buy in when the stocks are discounted, and that was exactly the opportunity in PayPal, since the shares have since recovered.
However, just like with growth investing, value investing also comes with warnings, including:
- Value is in the eye of the beholder. With the same information, two investors may estimate the value of a company very differently. Some consider only current earnings and assets, without taking growth into account. Others calculate forecasted growth and the cash flow it will generate.
- Just because a company is cheaply priced doesn’t mean it’s undervalued. Many value investors concentrate on the price-to-earnings ratio (P/E)—a calculation of four quarters of the company’s earnings, divided by its current stock price—to determine valuation. But a low P/E does not tell the entire story. The stock may be trading cheaply because it’s a dog. Consequently, further analysis is required. Having said that, if you determine you have a good value candidate, make sure that it’s P/E is indeed low, compared to its industry and its five-year historical average P/E.
So, where do you start when looking for an undervalued company? As I mentioned above, you do begin with a low P/E, which should be in the bottom 10% of its peers.
Next, the Price to Earnings Growth Ratio (PEG, or the P/E divided by the earnings growth rate over the same period of time)—which should be less than 1.
And lastly, the share price should be less than tangible book value (tangible assets divided by total number of shares outstanding). Tangible assets are assets that you can physically see and touch, such as buildings, machinery, cash and inventory—not patents or goodwill, or other assets that cannot be liquidated for cash.
That’s a short and simple analysis, but there are much more elaborate models to determine value, too.
Certainly, as mentioned above, there are investors—even famous investors—who favor one strategy over another. But for the average investor, it’s essential to note that markets cycle up and down. Sometimes, growth stocks are the big winners, but in other instances (say, an economic downturn, or just a period of uncertainty), investors prefer value-oriented companies.
Some of those cycles are depicted in the following graph (Figure 5).
Figure 5: Russell 1000 Annual Returns
You can see that no one investing style—value or growth—is always the best strategy to follow. That’s why many investors seek a more balanced portfolio that will include both styles—as well as others.
For example, Peter Lynch, the pioneer of the wildly-successful Fidelity Magellan fund, created a hybrid model of growth and value investing—the growth at a reasonable price (GARP) strategy. From 1977 to 1990, Lynch averaged a 29.2% annual return, making Fidelity Magellan the most successful mutual fund in the world.
Bottom line, a balanced portfolio is optimal for most investors, skewed toward whichever style suits your personal risk assessment. But growth and value are not the only strategy selections that you need to know about—there are lots more!