Growth versus Value investing
What is the difference between growth vs value investing? This is a frequently asked question, here we aim to help you understand these approaches to investing.
Growth investing can be summarised as allocating monies into companies that are experiencing high rates of sales growth whilst maintaining a future expectation of outperforming the overall market.
It is good to bear in mind that a growth company may or may not be profitable and it is unlikely to pay a dividend. Even in the situation of a profitable growth stock, the company itself may be cash flow negative. This could be due to both the high levels of capital expenditure and working capital that growth companies reinvest back into the business to maintain prodigious growth momentum.
Growth stocks are typically younger companies, but there are several growth companies that have been around for many years. Examples of growth companies include Tesla, Amazon, and Home Depot¹.
Generally, growth stocks command high Price to Earnings and Price to Book ratios². They also carry higher volatility and are subject to greater risk due to their weaker balance sheet positions. However, this greater risk is thought to result in an increased probability of outperformance. In strong markets, growth stocks typically experience supernal share price appreciation and capital returns.
They may also carry the risk that exceptional growth prospects are unsustainable, and the company may therefore fail to realise long term profitability. This happened to a number of high growth companies during the Dot Com bubble of the early 2000’s. It is important to understand a company’s prospect to the market as a whole and consider the endurability of supernormal growth.
Characteristics of a growth investor may be defined by the following⁷:
- A preference for long-term growth over income
- An ability to withstand high volatility
- A strong belief in the ability of stock pickers and active management
- An ability to remain invested long-term
Value investing is nearly the exact opposite of growth investing. Value stocks are those that are selected based on the present value of the company’s future cash flows, also known as intrinsic value, relative to the company’s current share price.
Value stocks tend to be mature companies with stable growth rates, operating costs, and profit margins. Value companies are often defensible businesses, with high levels of senior management success, consistent cash flows, transparent financial statements, and strong margins of safety³.
Value investing looks at companies with historically strong cash flows that may be neglected by the overall market. The companies may be trading at or below their Book Value or at a historically low Price to Earnings. These companies usually pay a dividend and have a long history of maintaining the dividend with sparing interruption³. Past examples include General Motors and Proctor and Gamble.
There are also risks associated with value companies, a phenomenon known in the financial world as the ‘value trap’. This is whereby investors purchase shares of a company that appear undervalued when, in reality, the company is distressed⁴. For a company experiencing a value trap, valuation metrics such as Price to Earnings, Price to Cash Flow, and Price to Book may be unusually low for an extended period⁵.
In addition to misleading valuation metrics, Jim Chanos characterises value traps as having an over dependence on a single product, high cyclical exposure, and accounting and management issues. Investors mistake low valuations of value traps as bargain opportunities⁶. In reality, the low valuations are a result of the company’s poor underlying performance which typically may only be revealed upon a detailed study of the company’s financial statements.
Characteristics of a value investor may be defined by the following⁷:
- A preference for immediate income
- A preference for stability and low volatility
- A preference for cash flow analysis and ratio analysis
There are many different reasons for investing and no two people will have exactly the same objectives. Determining whether a growth or value investing strategy is better, you must take into account, the level of risk that you, as an investor, may be willing to accept, as well as your time horizon to reaching your investment goals.
Risk is a necessary and constant feature of investing – share prices fall, economic conditions fluctuate, and companies can occasionally become insolvent. The risks cannot be avoided, but when they form part of a diversified portfolio and are managed collectively, they can be diluted.
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