Growth Vs. Value Investing: Which Style Suits You?
When making your investment decision, do you lean towards growth funds or value funds? Let’s take a look at both to see which type suits you best! While both growth and value investing styles seek to provide the best possible returns for investors, the primary differences lie in the approach, the way stocks are picked, and the types of markets for which they are best suited.
A growth fund tends to focus on companies that experience faster than average growth as measured by revenue, earnings, or cash flow. Generally, growth-oriented companies are also more likely to reinvest profits in expansion projects or acquisitions, rather than use them to pay out dividends.
Investors focused on growth investing will keep an eye out for stocks with growth potential that focus on newer and expanding companies which are likely to rake in profits in the future, and higher than the industry or the market in general. When you invest for growth, you are looking at capital appreciation over the long term.
As growth funds are expected to offer higher returns, they also generally represent a greater risk. They tend to do better than the overall market when stock prices are rising, while underperforming the market as stock prices fall. Therefore, investing in growth funds may require a higher tolerance for risk and a longer time horizon.
Factors to consider when considering a growth fund:
- Is the company able to grow substantially faster than its competitors?
- Is the company involved in a rapidly expanding industry (e.g. technology and healthcare, etc.)?
- Are you comfortable with profits being realised through capital gains instead of dividends?
- Can the fund achieve above average valuations such as high price-to-book and/or price-to-earnings ratios?
Pros and cons of growth investing
|Able to realise substantial returns in a shorter time span||Market downturns tend to significantly affect growth stocks significantly|
|Would potentially generate a good income stream if the growth stocks’ dividends grow in tandem with rapidly rising earnings||High expectations of companies’ prospects increase the probability of disappointment if the company does not meet investors’ expectations|
|The absence of a large margin of safety increases the probability of losses|
The goal of a value fund is to find the ultimate bargain. For example, stocks that have low prices in relation to factors such as earning, sales and net current assets of the company. A value investor will seek to buy stocks that are temporarily out of favour or at a bargain price. The value investor does so because he predicts that the share price will eventually return to a higher level when the stock comes back into favour, and the market will then drive the stock prices back up. Value investors usually do not follow the crowd, preferring instead to focus on a company’s fundamentals and take advantage of the market’s overreaction to negative sentiment.
There are various reasons why stocks become undervalued in the market. Sometimes, a company or industry could be going through hard times due to a fluctuating or a poor quarterly earnings report, negatively affecting its stock price for the short term. In this case, the value investor will look for a “margin of safety”, meaning that the market has discounted a security more than its market value, for example trading at a price less than its intrinsic value. Buying at a good bargain ensures that if the investment value drops, the losses will be minimal.
In general, a value fund will invest in mature companies that use their earnings to pay dividends. As a result, value funds tend to produce more current income than growth funds, although they also offer the potential for long-term appreciation if the market recognises the true value of the stocks in which they invest.
Factors to consider when considering investing in a value company include:
- Does the company’s business make long-term sense (e.g. financial services and utilities)?
- Can the company’s stock be bought at a discounted rate?
- Does it have a low price-to-book and/or price-to-earnings ratio?
- Does it have a high dividend yield?
Pros and cons of value investing
|Reduces probability of a large loss by purchasing equities with a high margin of safety||If a downtrend occurs, the shares may continue to become cheaper and cheaper (trading at less than intrinsic value)|
|Goes against the grain i.e. not following the crowd, where “hot tips” and fads do not impair investors’ judgement||Intrinsic value is subjective, two analysts can analyse the same company and derive at a different value|
|May provide consistent returns||May yield lower returns on an annualised basis|
The best of both worlds
So, which style of investing would suit your portfolio best? Well, the experts say that every investor’s portfolio should contain a combination of both.
As investors, employing a single approach only when investing over a long period of time may not be the best idea. Instead of choosing only one approach, an investor should strive to maximise returns while minimising risk by combining both growth and value investing.
This approach would allow investors to potentially gain whether the general market situations favour the growth or value investment style. These two types of stocks also tend to move in the opposite direction to a certain extent, so investors can enhance their potential for returns and reduce risk by combining the two approaches. Value funds offer investors more protection during sell-offs, while growth funds tend to lead during market rallies.
The wise investor knows and understands the differences between the two, but the wisest investor knows that a portfolio built around both growth and value stocks is the true path to investing success.