Growth vs. Value Investing: Two Approaches to Investing in Stocks

Daniel Penzing
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What Is Growth Investing?

If you want to grow wealth in a short period of time (say five years) then you need to invest in stocks that are expected to deliver the highest growth.

For instance, you want to invest in companies that are expected to experience a huge jump in revenue because of the advancement in a particular sector. You can invest in companies that will be disrupting a particular market causing already established companies to lose out on market share. You also want to invest in companies that are in the process of creating the next big thing.

If you’re investing a lump sum of money, a great strategy is to use the 90/10 rule. That means 90% of your investment money should be in a stock that is expected to deliver high growth and the remaining 10% should be divided between two to three stocks that you hope will deliver medium to low growth. If one of those stocks doesn’t work out, it won’t have a significant impact on your returns.

If you’re trying to steer clear of stocks that will cause your stomach to churn then you should use the Rule of 100. In this case, your portfolio should consist of about 100 stocks that deliver the same level of returns. If you’re planning to invest in a few stocks that are expected to deliver growth, then you can use a mini portfolio (10 to 20 stocks).

Pros of Growth Investing

The growth approach looks for companies that are growing earnings quickly. This approach targets companies that are poised to take advantage of an inevitable growth in a fast growing segment of the economy.

>When the growth in revenue and income are clearly evident, the company becomes more valuable. That is the intrinsic value of the stock.

Targeted Growth Companies

Growth investors look for companies that want to grow revenue and income. Those companies are not necessarily mature. Many companies will venture into niche markets that are just beginning to grow. Growth investors also invest in mature companies, as long as they are growing at a faster rate than the overall market.

Each company is reviewed as a stock. Differentiating factors are the growth rate of the company, what caused it, and the prospects for future growth. In this approach, the performance of the company matters more. Growth investors don’t have to stick with the same company. If the company has grown as expected, they can capitalize on this growth by selling their stocks, and then look for another company with growth potential.

What Determines a Company’s Growth Potential?

Growth investors are looking for market opportunities. It’s the job of growth investors to recognize the next big growth market.

Cons of Growth Investing

What Is Value Investing?

Value investing is a strategy that emphasizes the selection of stocks with the most favorable growth prospects at the lowest possible prices.

It represents a popular investment strategy because its premise is simple and the results are easily measured. It seeks to find a stock’s total value by estimating future prospects and then finding stocks that have a price below that value.

Although the basics of value investing are easy to understand, its practice can be complex and time-consuming, particularly if you choose to run a screen or conduct a detailed valuation of the companies you consider investing in.

Investors who practice value investing tend to be long-term owners, doing the most trading when stock prices are at their lowest.

Growth investing, by contrast, focuses more on the growth potential of the stock – the company’s earnings, sales, or general market conditions. It also doesn’t focus on price. Rather, it focuses on the potential for the stock to increase in price over time.

When investing in a company, growth investors look at the book value of the company, the company’s fundamentals, the company’s future earnings, and whether the company is a good value.

Pros of Value Investing

There are more than a few advantages to being a value investor. Over the long term, value investing tends to deliver stronger returns than growth investing. In addition, they are able to mitigate the downside of a downturn in the market.

Better Returns Value investors tend to generate better returns long term than their growth counterparts. That’s because growth strategies are focused on capital appreciation. Even though they are touted as “high risk” investments, if the stock is rising 10% each year, you are taking on some pretty high risk!

In addition, when you combine the risks associated with growth investing, such as the risks associated with timing market movements and guessing about which growth stocks will perform well, the volatility of returns increases. As a result, over the long term, your investment thesis can be way off base.

Of course, there are certainly cases where growth investing will outperform value investing. But the efficient markets hypothesis states that in the long term, the stock market will hit a point of equilibrium where there are no stocks trading at a discount or premium. Since the value stocks are unlikely to a grow faster than the overall market, this only serves to add further to the valuations of the stocks you’re likely to find.

Cons of Value Investing

Value investing may be an easy concept to learn, but when it is applied in practice, it might not be so easy to do. One of the main challenges is in determining what price to pay for a stock.

One way to do this is to look at the historical price of the stock. Doing this is called using a DCF or Discounted Cash Flow model. With this approach, one would take the expected future cash flows of the business discounted back to present value.

So, with this method, you have to project whether the company will be able to deliver on its projected growth and cash flows.

There is some information that you can easily find out, such as the company’s revenue and net income. Some of the information is not available easily – such as the projected growth rate or the profitability of the new products that the company may come up with.

With a lot of work, you will be able to make an educated guess. You will have an advantage over other investors if you can figure out how to calculate the growth rate and more importantly, the payout of free cash flow to the shareholders.

Growth vs. Value Investing — Which Is Better?

Over time, the people who have started taking part in the stock market have developed certain methods of investing. These investment methods are nothing more than a way of classifying the investment styles of various investors. “Traditional” methods of investing are as diverse as the individuals who use them, and where the individual investor ends up falling into depends on his own style. There are two main investment styles that most investors are familiar with, and they are Growth & Value.

Growth — Growth investors who largely focus on buying stocks that they believe will show strong growth in the future. There are a few common metrics growth investors use to determine how strong a company’s growth is. One of the most common is price-to-earnings (P/E) ratio, a stock’s price divided by its earnings. A more expensive stock’s high price-to-earnings ratio is a red flag to traditional growth investors because it means the company may not generate enough earnings to warrant such a high price. The higher the stock price, the higher the potential reward, but, also, the greater the risk. Growth investors tend to be willing to take more risk because of potentially larger future gains.

Combining Growth and Value Investing

The growth and value investing approach to investing in stocks involves two separate frameworks but the idea is to use both of them to help identify great investment ideas.

Imagine that you own a business, and you are making a decision about hiring new employees. You could just hire anyone who applies … but is it a good idea?

You could go to an employment agency and hire anyone they match you with, but is that a good idea? That is where having a strategy or framework comes in.

A common framework is to use a growth investing strategy—that means hiring employees that have demonstrated potential for growth.

Perhaps more importantly, you could also use a value investing strategy—that means hiring people who are likely to add more value to your organization. In a way, what you are doing is maximizing the return from your existing capital… investing in potential future growth and enabling your current employees to create more long-term value.

In investing it’s no different. Applying both a value investing framework and a growth investing framework is generally considered the prudent way to invest.

Bottom Line

If you’re new to investing in stocks, it can be somewhat overwhelming to make sense of all the different approaches suggested by advisers and the internet.

One way to think about the investment approaches is in terms of their focus.

Value investing focuses on how the prices of different companies’ stocks will change.

Growth investing focuses on how the stock price will change in the future.

To begin with, you might be more likely to suit one investment approach rather than the other on the basis of how risk averse you are.

If you are more risk averse, it’s more likely that you will focus on investing in stock that you think has a low price and will go up in the future.

If you’re more risk averse, it’s more likely that you will focus on investing in stock that you think has a low price and will go up in the future.

If you’re more risk tolerant, it’s more likely that you will focus on the stock’s value because it has a low price and you’re not worried that the stock will drop by a lot.