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Value investing vs Growth investing



Value investing and growth investing are two different investing styles. These two styles compliment each other and having both of these is an advantage to your portfolio. The goal will be to weigh what is better for you, understand the risk and opportunities in both styles and make wise decisions.


Table of contents

  • Growth investing

  • Value Investing

  • What is the PE ratio?

  • What is the P/B ratio?

  • How to pick a value stock

  • How to pick a growth stock

  • Stocks in the long run: Things to keep in mind

  • Conclusion

  • A super important TIP

  • What to do now

Growth investing



These investors are trying to invest in those companies that are growing faster than the market to earn a bit higher than average returns. It's about finding the next big technology, app, or groundbreaking product which has the potential to dominate the market. These are particularly attractive for beginners or those who are trying to get a hang of stock picking.


They try to screen companies that are particularly 5-10 years into the rapid expansion of around 20% and sometimes these companies can tend to be smaller and younger. This can be hard to achieve for a bigger company because it has already achieved this feat already. But these days, goliath companies like Microsoft and Amazon continue to grow rapidly at a CAGR above 20%.


These companies try to build up their revenue, often at the cost of delaying profitability. After a point in time, they start focusing on profits. Growth companies tend to have high price-to-earning and book value ratios but see faster growth in revenue and income compared to their peers.


Value Investing



These investors are ready to put their money around more boring and stable companies that might also be experiencing a decline in performance. The primary criteria aren't how big the company is instead investors here see the value the company has. This is a bargain the investors look to hunt and paying 95 cents for a dollar is the value. So, value investor looks at the fundamentals of a company and identify these stocks which are selling less than what they should be.


By finding these stocks, the investor stays put and waits till the prices return back to their original intrinsic value (Value which the company should be), thereby profiting from this. In some cases, investors put their money in declining companies or bankrupt companies in an analysis that they will get the money back in the future or in the liquidation process.


What is the PE ratio?



Price to earnings ratio is a common analysis tool used to evaluate the present stability of the company. We divide the current share price with the earnings per share of the company. The share price is the price that you see on the screen when you pick a company. Earnings per share are got by dividing the earning of the company in that annual (year) by the total number of shares the company has. This tells how much I am paying per Dollar of annual profit. By this, we can see which company's stock prices are cheap and which are expensive.


What is the P/B ratio?



The price to book value ratio is a common analysis tool to see the financial stability of the company. We divide the current share price with the book value of the company. Book value is the money you will get once the company liquidates itself (sells all its assets) and converts it into cash. Here book value is the book value of the company divide by the total number of shares of the company. This tells how much return I might get for every dollar spend.


How to pick a value stock



We learned about the P/E ratio. We can compare different company's P/E ratios and see which company stocks are running cheap. For example, a value investor finds a company XYZ trading at a P/E ratio of 5. This means the company is trading at 5 times its value. This is proportionality less compared to the other companies which are trading at P/E ratios of more than 10.


The investor does some research on the XYZ company on various parameters (management team, fundamentals, technical) and sees that the company is worth buying and it will perform over time. But here he might see a danger that the company price is declining every day but still he decides to move forward. The investor buys the stock, knowing that even though the price is low, they aren’t paying too much compared to the valuation of the company. This brings less risk if things don’t go the way they expect.


Oftentimes, the investor sees a good company with a longer track record of success which reduces the likelihood of drastic change impacting their stock price. The drawback is that it can take a lot of time for the stock price to come up, maybe 15-20 years.


Value trap: Value investors can fall into a trap where they buy cheaper stocks, but after buying, the price goes down and down making it cheaper and cheaper. This happens if the company is deteriorating or in the worst case going bankrupt. Just because the stock is cheap, it doesn’t mean the stock is a good buy.


FACT: According to a study conducted by Bank of America, Value stocks outperformed growth stocks over a 90-year period (1926-2016). Value stocks earned 17% annually compared to 12.8% of growth stocks.


How to pick a growth stock



Growth stocks tend to be more expensive and often have high P/E ratios. Typically, these companies trade at 30-40 P/E ratios. But since these companies have higher to average growth, they attract a lot of investors which leads to higher valuation (expensive). The P/E ratio suggests it has a higher stock price and lower profitability. This is by far due to the assumption that the company will keep performing better and investors see potential growth in these companies. This might make the investor harder to get a return because you are already paying a higher price for the stock, it takes time for the price to move up.


For example, think about a tech company XYZ trading at a P/E ratio of more than 30. The investment might seem to be expensive, but the investor might buy the stock if they see that the underlying company is growing rapidly. If the company doubles its operations or revenue, the stock wouldn’t seem that much expensive for what the investor paid for.


Finding the company early on which might dominate the field can make those involved fairly wealthy. But this stock is brought on the promise of future exceptional growth, oftentimes without the history to support it.


FACT: From 2007 to 2017, growth stocks outperformed value stocks by a fairly large margin.


Stocks in the long run: Things to keep in mind


Volatility: This is a measure of how much people are buying and selling a particular stock. The higher the volatility more unstable will be the price. The price tends to fluctuate 3-4% a day. But the returns over a year will be fluctuating between 30-40% as more people will be keeping eye on this.


So, Tata Motors is a highly liquid stock with high volatility, we can see a -40% one year, then +30% next year, then +35% next year. The fluctuations can go like this for a growth stock. But if an investor sees potential growth in Tata motors, he goes ahead and invests in the company. He will be seeing returns in the long run.


If we see value stock, the fluctuation will be very less, volatility will be very less, the people having an eye on this stock will be very less, but they will give a consistent return in the future. The stock fluctuates in the range of 8-10% a year, but a good value stock gives a consistent return overall.


Conclusion


There isn’t any clear winner when we see the two. When the economic conditions are good, bull market, economic expansion, growth stocks modestly outperform value stocks. But during difficult economic times, bear market, recession times, value stocks tend to outperform and be stable. Thus, which performs better depends on various factors like economic conditions, sector performance, time period, etc. Many people tend to hold both growth and value positions to diversify their portfolios.