Wednesday July 18, 2007
Growth versus value investing
Ooi Kok Hwa
Value investing means searching for stocks selling lower than their value, whereas growth investing is finding companies with growth potential. Failure to pay attention to any risk factors may result in unintended lossesQ: Which one provides better return, growth or value investing?
Choosing between growth and value investing is always a tough decision. Value investing is concerned with the current price level and fair price of a stock, while growth investing is more focused on the potential earnings growth of the company.
According to Warren Buffett, the term “value investing” is redundant because “investing” is definitely an act of seeking value, at the very least, sufficient to justify the amount paid. He believes that growth is always a component in the calculation of value. For every dollar used in investing, it must create more than a dollar of long-term market value.
Value investing
The principle behind value investing is using the market approach, which is concerned about the current price level of a stock. Therefore, ratios such as price earnings ratio (PER) and price-to-book are used and special attention is paid to the price component of these ratios.
When using the PER method, a low PER is preferred, as investors believe the current low price level may be due to an overly pessimistic assessment of the company’s future prospects. The PER will eventually revert to its normal market level when other investors realised that prospects are not as bad as they thought.
As a result, they rely on the movement in stock price rather than the earnings. They will search for companies with low PERs, as they expect the ratios to increase to their normal levels with or without an increase in earnings. However, value investors face the risk of misinterpreting a cheapness signal when the market’s concern about the stock may indeed be correct.
Growth investing
This method is based on the earnings potential of a company. By assuming the PER will be constant, investors anticipate that higher growth in earnings will contribute to higher stock prices.
Benjamin Graham, the father of value investing, defined a growth company as one that has performed better than the average company over a period of years and is expected to continue doing so in the future.
Growth investing is a method of identifying companies with average growth prospects. Its focus will be on the potential growth in earnings, which has not yet been reflected in the current stock price.
Here, the key risk is the non-occurrence of the expected growth. In some cases, growth investors may be entirely vindicated in their judgment of the quality of the underlying business, but the stock still performed badly because it was so overly priced at the time of purchase.
In addition, this method assumes a constant PER. If the PER declines for some unanticipated reason, the investors will incur losses as a result of lower stock prices despite a higher growth in earnings.
Buy low, sell high or buy high, sell even higher?
Value investors are always the earlier buyers of stocks. They buy based on the belief that the market has misread the real value of the company. At that moment, the future prospects of the company may still be uncertain; there may or may not be an increase in earnings.
Thus, in addition to using the PER, value investors will use other measures, like dividend yield or price-to-book ratio, to support their purchase decisions.
In contrast, growth investors will come in at the early recovery stages of a company’s fundamentals. At that point in time, the stock’s price will have already moved higher from its recent low. Value investors will usually start to feel uncomfortable with the price level and sell the stock even though the company’s fundamentals have recovered, while growth investors will buy the stock in the belief that they are buying high to sell even higher.
Growth investors believe that it is safer to buy stocks when the fundamentals have shown definite signs of recovery, and will sell higher when the prices increase as a result of further improvement in the companies’ fundamentals.
Hence, both value and growth investing have their strengths and weaknesses. Failure to pay attention to their risk factors may result in unintended losses.
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