Growth versus value investing

 

Let me guess you're a value investor. Sorry for you son. apple, tesla, amazon, you're missing out grandpa! everyone knows that value is dead. Wait wait wait don't tell me that you're a growth investor. Only another walnut would buy the same thing as everyone else and think they're going to beat the market. 

You couldn't find great value if you were in the grocery aisle at a walmart. that's right! ladies and gentlemen we are back again with another face-off: growth investing versus value investing. 

Admittedly it's not as fierce as debate as active versus passive. But, it's an important one to understand. nonetheless these are after all two of the most popular fundamental approaches to investing. And chances are you're actually employing one of them right now if you invest actively through a mutual fund or etfs. But while both styles of investing belong to the same school of thought, they employ polar opposite criteria for selecting investments. so let's go over growth and value investing and how they square up.

 Growth and value investing form a sort of dichotomy within the fundamental school of investing. Growth investing on the one hand is the fast and furious approach, that has been particularly popular and successful over the last few years whereas value investing is the slow and steady philosophy made popular by warren buffett himself. The two approaches are broad in nature and themselves can be further divided into many different strategies. But you can generally categorize stocks under one of these two approaches based on three characteristics.

 

The first of which is the growth of the underlying company. By growth here we're referring to how quickly a company's revenues, profits and or cash flows are increasing on an annual basis. And when it comes to growth investing, this is the primary focus. Naturally you see growth investors are trying to invest in those companies that are growing faster than the market in a bid to earn higher than average returns. It's about finding the next big thing that new technology app or groundbreaking product that's taking off and has the potential to dominate the market, making it particularly attractive for beginners who are trying their hand at stock picking.

 Generally the investor will screen companies that have experienced at least a couple years of rapid expansion. Oftentimes anything above 20 percent. Because of this requirement these companies tend to be smaller and younger as it can be difficult to achieve these higher growth rates when you're already larger or more mature. But this isn't a requirement for growth investing these days. There are a number of more mature goliaths like microsoft and amazon that continue to grow rapidly. So it's common to find these two companies labeled as growth investments despite their huge size.

 Now value investing on the other hand doesn't really look for those flashy companies that are breaking records or promising to change the world as a result. These investors are more willing to put their money behind more boring and stable companies, that are likely more mature and in some cases may even be experiencing the decline. This isn't to say that value investors don't want growth in their positions but, it isn't the primary criteria they use to pick their stocks. 

That instead comes from our second criteria the stocks valuation. As the title implies value investing is about being a bargain hunter. Finding the diamond in the rough and paying 95 cents on the dollar for your position. The thinking is that stock prices often deviate from their true worth or their intrinsic value. So value investors will try to identify stocks with solid fundamentals that are currently selling for less than what they should be. By finding and buying these companies the investor will profit when the stock price eventually corrects itself and returns to its fair value. 

With this style it's common for investors to focus on more mature companies, that are currently out of favor with the market because of some temporary headwind. Although some value investors will put money in declining or even bankrupt companies, if they believe that they'll get more money back than what they put in through the liquidation process. 

Now there are many approaches for determining the value the intrinsic worth of a stock but an easy one for comparing value and growth stocks is the p/e multiple which divides the stock's price by its earnings per share, to show the investor how much they're paying per dollar of annual profit. There are other multiples you can use here, that might be more appropriate, including price to book value or ev2 ebitda, but for simplicity's sake we'll stick with p/e. 

The p/e ratio shows how much an investor is willing to pay for stocks operations and by comparing it to the multiple of peers and the market as a whole, investors can see which companies are cheapest in their industry.

 For example imagine a value investor finds a bagel company, that's trading at a p/e multiple of five times, compared to other bagel companies which are trading at a p/e of 10 times, the company appears to be cheaper and while the stock is currently out of favor with the stock market, the investor carries out some research and determines that the company has a good management team and strong fundamentals. So with the belief that the company will eventually return to a 10 times multiple, the investor will buy the stock. knowing that even if things stay flat they aren't paying too much for the stock. So there's less at risk if things don't go the way they expect.

 Now value investors don't buy stocks just because they're cheap. They will carry out the fundamental research to make sure that their holdings will perform well over time. And in some cases they might even experience high growth. But the idea is to limit how much they're paying for these stocks.

 Growth stocks on the other hand tend to be more expensive and will often have fairly high  p/e ratios. It's not uncommon to find these companies trading at 30, 40 times even, 100 times their earnings. Within the growth universe sometimes the multiple doesn't even apply because they don't have earnings to back up their valuation. Because these companies are reporting higher than average growth though they tend to draw a lot of investor demand. Which is what leads to these higher valuations. A higher stock price compared to lower profitability.

 Now this can make it harder for the investor, to earn a return because you are paying a premium for these stocks. You'll need to earn more to justify the investment. But growth investors will pay this price if they believe the growth of the stock is worth the price tag. 

For example imagine a growth investor finds a tech company that's trading at a p/e multiple of 30 times. While this multiple may seem expensive, the investor might buy the stock if they see that the underlying company is growing rapidly. If the company doubles its operations in a couple of years the stock won't seem so expensive for what the investor paid for it. So the growth of the underlying company and the valuation of its stock are two key characteristics of value and growth investing. and each style focuses on one of these two characteristics.

 The final differentiating factor is the stock's volatility or how much the stock's price is fluctuating. Now this isn't something investors are inherently screening for, when they're deciding which company to invest in. But because growth companies tend to be younger firms with higher valuations, their stock prices tend to jump around more than value stocks which often are more stable. 

So while a growth stock may experience a stock return of thirty percent one year, negative forty the next and then sixty percent. A value stock will often be a quite bit more boring perhaps. Returning a consistent eight percent a year. So those are the traits that differentiate the types of stocks each approach focuses on. And as you would imagine, each style exposes the investor to a number of different advantages and weaknesses.

 For growth investing the main pro is the higher return potential as you would probably expect. Actually finding a company early on that does go on to dominate the field can make those involved fairly wealthy. The cons however are that this tends to be a more risky approach. Not only are these stocks more volatile, but growth stocks are often bought and sold on the promise of future exceptional growth, oftentimes without the history to support it. This is a problem when you consider that investors are paying a premium for these stocks. If investors pay a 30 times multiple for a company that's been growing 40 percent a year and next year the company reports a measly 5 percent growth, the valuation has a long way to fall if the market suddenly removes its growth premium. You might hear for example that these companies are priced for perfection. Meaning that anything that falls short of that can really hit the stock price. 

When it comes to value investing the pro is that it's often the boring approach. Meaning that it's less volatile and less risky. Typically a value investor will put money behind more established companies with a longer track record of success. Which reduces the likelihood of some drastic change impacting their stock price. The cons are that it can take a lot of time for the value of a stock to surface. sure you might identify a stock that's undervalued, but if it takes you 20 years to see the value redeem itself then it might not be a good holding. On top of this value investors can fall victim to what's known as the value trap, where they focus too heavily on buying cheap stocks and end up with crappy positions that are only getting cheaper.

 You see just because the stock is cheap doesn't mean that it's a good buy. And there's always a chance valuation will fall further than what it currently is, if the underlying business is deteriorating. Sure you might find a company at a five times multiple. But if it goes bankrupt it's all for naught.

 As you can see both styles present different opportunities and drawbacks. But which one is the superior approach? well the answer to that depends on when you ask the question. According to a bank of america merrill lynch study, value stocks outperformed growth stocks over a 90-year period. Starting in 1926 earning 17 percent annually compared to a growth 12.6 percent. However growth stocks have taken the crown over the past decade having outperformed value stocks since 2007 by a fairly large margin. For some this signals that value investing is dead, for others it's but a sign that the markets have become too optimistic and that a reversal is just around the corner.

 Regardless you can see that value and growth investing perform better during different periods of time. With growth stocks often taking the lead during extended bull markets. But here's the thing. while some people might religiously follow the tenants of the value investor or lambast, anyone who isn't buying the latest and greatest stock you can apply aspects of both styles. Many people will hold both growth and value positions in their portfolio to diversify their positions and there are hybrid strategies out there as well. garp for example stands for growth at a reasonable price and it involves investing in growth companies with solid fundamentals that aren't too expensive.

 So there are some approaches that kind of balance the two. so while many of us like to identify as being either growth or value investors, the truth is that we're all just looking for solid companies to put our money behind. so there's no need to compete. besides, some of us are just better at investing than others and that's nothing to be mad about. what? what are my returns? that's that's confidential information. 

You've probably heard before, that many of the most successful business people and investors in the world are avid readers. buffett himself is known to read five to six hours a day. So if you are falling behind on their reading list checkout blinklist.com. Blinkist is an app that condenses thousands of different books and lets users read or listen to their key insights in 15 minutes or less. Personally I find it great for when i'm commuting or doing chores. And the great thing is that because the books are split into many chapters called blinks, you can still learn something new even if you only have a few minutes to spare. As for the topics you can find they have some really great picks on investing,and many other topics. For anyone falling behind on their reading list I think you'll really enjoy blinklist.

thanks for reading if you have any feedback or topics you want me to cover leave a comment down below