Thursday, August 23, 2012

Value vs. Growth Investing

If you have done any research on stocks, mutual funds, etc., you have probably heard the terms value stocks and growth stocks. These two adjectives are used to describe the underlying motivation and strategy for investing in a particular security. Many (if not most) investors and the media portray these two as distinct camps with clashing investment ideologies.

Benjamin Graham (1894-1976) is hailed as the
father of value investing
Proponents of value investing favor low priced stocks, selling below their intrinsic value. Typical characteristics of value stocks are low price/earnings (P/E), price/book (P/B), and high dividends. The idea is that over time, the overall market will realize that the stock is undervalued and correct itself accordingly. As such, it is associated long term investors.

On the other hand, growth investing is a matter of investing in companies with higher than expected growth rates. The premise is that the stock price reflects the opinions of Wall Street analysts on earnings and cash flow. If the company beats these expectations, then the stock price will move up. In order to facilitate high earnings growth, these stocks typically have low or no dividend yields.

Now let's take a step back...

So far, we know that the stock price is the market's valuation of a company. Thus we should always invest in companies that are currently being undervalued in order to make a profit. This sounds exactly like value investing.

The question then becomes, how do we determine the value of a company? Well at first glance, we can take into consideration the company's physical assets like land, equipment, and inventory. That gives us the book value. But a company isn't a static entity; the whole purpose is to generate revenue and profits. Thus the value of a company must inherently take into account the future cash flow, including all growth of said cash flow.

And so we arrive at the conclusion that the value investing must necessarily use principles of what's known as growth investing.

Vice-Versa

The same conclusion can be drawn about growth investing. During the late 1990's and early 2000's of the dot-com bubble, a common investment principle was "growth at any price." The faulty premise being that as long as the company will grow, any stock price is justified. As a result, stock prices of technology companies like Amazon skyrocketed far past their intrinsic value.

Since then, "growth at any price" has fallen out in favor of "growth at reasonable price". But what constitutes reasonable? In order to determine a reasonable price, one must evaluate the value of a company, taking into account both potential for growth and assets. Then, like value investing, you buy stocks are are undervalued according to your calculations.

Conclusion

In Warren Buffett's own words: "growth and value investing are joined at the hip". You cannot be one, without being the other because growth is tied into value. Fundamentally speaking, there is absolutely no point in differentiating the two.

And here's another quote from Buffett:
Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication.

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Obligatory Disclaimer

The author is not qualified to give financial, tax, or legal advice and disclaims any and all liability for this information.