Although such division is often deemed artificial, style of investing is an important behavioral trait that helps to determine assets suitable for one’s portfolio. So almost in every article about stock market one can spot a division for ‘growth’ and ‘value’ stocks. ‘What’s it all about and which ones are the most suitable for me?’ would one ask.
Value investing concentrates on buying a stock at a price lower than its intrinsic value. Intrinsic value is a price to which the stock should (in theory) converge on a longer time horizon. Value companies are usually characterized by a high dividend yield but what value investor is really looking are low trading multiples. For example, BP currently yields around 7% of dividend income per annum. At the same time, the company has low margins and the multiples are therefore very high – so the price is not justified by the underlying financials. It is not undervalued in terms of fundamental factors and is not a value stock.
A true value stock is cheaper than the investor believes it should be – for any reason. There might be different sources of underpricing – namely negative publicity, a decline in the market or one-off losses that are unlikely to recur and so on. Value investor mostly seeks for a ‘hidden gem’, a company that is for some reason overlooked by the majority of other investors so in general, such investors don’t trade that often.
The major problem in value investing is to distinguish the stock which is undervalued relative to its underlying fundamental financial factors from the one that is really is in a worse financial shape. In the latter case potential return is greater too – but so is the risk. Buy cheap – that’s the philosophy of the value investor.
Unlike those looking for value, growth investor is focused on finding companies that can demonstrate growth at rates higher than the market on average. These companies may appear greatly overpriced at the moment as indicated by trading multiples but the future increase in profits should compensate for this.
A bright example of a growth stock is Amazon (AMZN) which is trading at P/E ratio of about 170x – that means that it will take the company around 170 years to return money through earnings. Amazon offers no stable income – it neither paid any dividends in the past nor is it going to do so in the future. It is constantly investing its profits in new business opportunities and ensures future price growth. As a result for the last 5 years the stock grew by 360% while NASDAQ index increased by a more modest 92% (as at March 10th 2017).
Growth stocks tend to outperform on volatile markets while in the periods of stable growth they tend to underperform.
In fact, growth and value investing are two sides of a single coin. Both these investment models are focused on identifying undervalued securities and distinguishing the ones that are cheap due to temporary market imperfections from those that bear higher investments risk and excessive return is merely a compensation for it.
These investment models take into account fundamentals of the company. Potential alternatives are concentrated on the technical analysis of the market. For instance, momentum investors trend to buy stocks following recent trends. First, a time horizon is determined – say, 3 months. After that, the investor buys stocks that outperformed the market on that horizon and sells the ones that underperformed. Such investment style works best on an upward trend and generally underperforms on bearish or simply quite volatile markets where the trends are not persistent.
Any investment decision should be made taking into accounts the actual circumstances, constraints, and goals of the particular investor. Such restrictions are usually formulated in the investments statement. Why is this statement important and how it should be prepared? We’ll address this in the next article.
Mikhail Chepkiy, CFA