(Part 3 of 3) ? Growth Versus Value Investing - Personal Finance ...

Big Idea ? Investing ? Stocks

Objective ? Readers will be able to differentiate between growth and value investing.

Investing for Value or Growth

When investing in stocks you are taking a risk - the higher the risk that you take, you demand a higher?potential return.? Two of the major strategies investors use to pick good investments include fundamental analysis and technical analysis. ?The differences are explained below:

• Fundament analysis ? Picking investments based on financial statements, earnings projections, potential new products and other financial factors.? Ratios that investors look at include the?price-to-earnings multiple (P/E), dividend yield and growth, price-to-book value of a firm, and earnings per share (EPS).?
• Technical analysis ? Picking investments based on price trends and movements, moving averages, chart patterns, analysis of historical data, and many other relationships.

Today?s post focuses on fundamental analysis, and two major approaches including growth and value investing.?? Among other factors, investors focus on the profit of a company, and how the market is valuing the company based on that profit expectation. Some investors focus on stocks that offer value, and others focus on stocks that offer high potential earnings growth.

Investing for Growth?

When investing for growth, investors are concerned with the future earnings growth of a company.? Earnings are typically measured by the EPS (earnings per share).?? This number can be tracked and found in the company?s financial statements, on a brokerage research report, Yahoo finance, or many other sites.? The EPS is calculated as follows:

There are three types of EPS numbers:

• trailing EPS, which uses the previous year?s earnings
• current EPS, which uses the current year?s earnings
• forward EPS, which uses the projected earnings for the next year

A shareholder earns a share of the company?s profits, and you want the company to grow its earnings. ?A few typical characteristics of growth stocks include the following:

• Pay no dividends or small dividends, as growth companies usually invest profits to finance future growth.
• Higher P/E ratios?than income stocks or value stocks-
  • The P/E ratio is how much an investor pays per share (stock price) relative to each dollar of earnings.
  • As the stock rises and EPS remains constant, investors are paying more for their share of a company?s future earnings.
  • If a company earned $1.25 over the last year and the stock price is $50, the P/E is calculated as follows:

• The P/E of the S&P 500 has averaged approximately 15 over the last century.? Growth stocks typically have P/Es that are well above 15.
• Price-to-Book Value ? Typically, growth stocks have a market value (market capitalization) that trades at a higher premium to the company?s book value (Assets ? Liabilities = Book Equity).

Example of a Growth Stock?

In isolation, the measures mentioned above cannot tell the whole story of a stock?s value.? Investors need to compare these measures across stocks in a similar sector and industry to discover relative value and opportunities.? Growth investors try to identify companies with high historical earnings growth, and more importantly the prospect of high forward earnings growth.? For this, investors are willing to pay a higher P/E and market value for a company?s growth.? For example, assume that two companies have the following details:

Company	Latest EPS	Stock Price	P/E
ABC	$1.50	$15.00	10
DEF	$1.50	$45.00	30

?

Why would an investor want to pay a P/E of 10? ($15 for $1.50 in profits) for Company ABC and a P/E of 30 ($45.00 for $1.50 in EPS) for Company DEF? Investors in company DEF are investing in faster potential earnings growth.? Consider the following:

• The market is pricing that company DEF?s earnings are expected to increase much more quickly than company ABC?s earnings.
• In return, investors are willing to pay a higher stock price, or higher P/E, for the potential of earning a portion of DEF?s explosive earnings growth.
• DEF is considered riskier than ABC based on its higher P/E.
• Though the companies have similar prices, ABC?s P/E is 1/3?of DEF?s P/E. ?This may suggest investors believe DEF has significantly higher earnings growth prospects than ABC.

Value Investing

The table from above can be used to discuss value investing too.?? Assuming companies ABC and DEF are in similar industries, you can compare the companies across a variety of factors. Similar to what I asked before ? Why would an investor want to buy company ABC with a P/E of 10, as opposed to DEF with a P/E of 30?? Assuming other factors remain constant, a value investor would construct the following arguments:

• Value investors argue that the market may undervalue a company at a point in time, in this case ABC.
• A stock that has a lower P/E relative to similar companies may be considered a ?buy,? and a higher P/E stock may be considered a ?sell.?
• Companies sometimes go through difficult periods and the market may overreact by driving the stock price below investors? perceived market price. Value investors look to capitalize on this cheap valuation.
• Though value investors focus on low P/E, low price-to-book value, low price-to-sales ratios, and higher dividend yields, it is equally as important to have a forward looking thesis for buying a value stock.?? Thus, investors must value the company based on forward earnings, and use this valuation to justify a good stock versus ?value trap.?
• In the table from the previous example, value investors would argue that if ABC has similar characteristics and prospects as DEF, then ABC?s low P/E reflects a buying opportunity.

All stocks that have fallen in price are not ?value? stocks.? Some stocks have low P/Es for a good reason, as they represent not only bad stocks, but also bad companies.? A ?value trap? involves buying a stock that you think is a bargain, but in reality it is a company whose prospects have stagnated.?? Thus, the ?cheap stock? deserves a lower P/E and cheaper market value.? It is important to compare companies and differentiate a cheap stock from a bad company.? If you don?t do your analysis, investors can fall into a ?value trap.?

Historical Performance ?- Growth Versus Value

From 1992 to 2011, the S&P 500 Growth Index averaged an annual return of 9.30%, and the average annual return on the S&P 500 Value index was 8.98%.¹? By this measure, growth has outperformed value.?? However, during this period growth investments had higher annualized volatility relative to value investing, with volatility of 21.33% and 17.87%, respectively.¹? Sophisticated investors measure risk-adjusted returns, which includes how much the investment returned for the level of risk you took.? Said differently, you can earn $100 in two different ways, one relatively risky and one less risky.?? Investors prefer earning $100 in the least risky way possible.? It is superior when you can earn higher returns that are not driven by taking excess or incremental risk.

The Sharpe Ratio is a measure of this risk-adjusted return.? It measures the expected excess return of investment versus a risk-free investment, and divides it by the historical volatility of that return.? In short, it shows how much of a return an investor can ?expect? above the risk free rate, but then calibrates it for the risk of the investment.? Clearly, the higher the numerator (expected return) and the lower the denominator (volatility or risk) implies a higher Sharpe Ratio and larger returns for less risk.? From 1992 to 2011, value investing has provided a slightly higher Sharpe ratio.¹

The data presented above and referenced in the source below are subject to bias.? The period of 1992-2011 is no indicator of future performance.?? It would be prudent for any researcher or investor to evaluate how growth and value strategies have performed in different decades and both secular bull (stocks going up) and secular bear (stocks going down) markets.

Takeaways

When considering a growth or value investing strategy consider the following:

• Growth investors focus on explosive earnings growth and are willing to forsake dividends.
• Growth investors are willing to pay higher P/Es, and these stocks can be riskier.
• Value investors look for ?bargains? and tend to focus on lower P/Es, lower price-to-book values, and higher dividend yields.
• Some studies have shown that value investing has marginally outperformed growth investing over longer periods in terms of total return.
• It is important to consider risk-adjusted returns, such as the Sharpe Ratio, and not just total return.
• Typically investors can manage risk better and earn better risk-adjusted returns by combining a growth and value diversification strategy.

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Assessment-

1.? How do value and growth investments differ in terms of P/E ratios and price-to-book value?

2. ?What is a main risk of investing in growth stocks?

3.? What is a main risk of investing in value stocks?

4. Does a stock price of $600 imply that it is riskier than a stock that is $60?? Why or why not?

Answers to yesterday?s questions-

1.? What are some differences between small-cap and large-cap stocks?

• Historically small caps have had a higher average return, but they are have been more volatile.

• Small-cap stocks tend to reinvest profits, as these stocks typically have higher future growth expectations.

• Small-cap stocks have market capitalizations below $2 billion, and large-cap stocks have market capitalizations above $10 billion.

2. How can knowledge of stock classifications help you with your investment portfolio?

Knowledge of stock classifications can help you understand the risks and potential returns of stocks in different economic cycles.? ?Classifications will help you better understand how stocks correlate with each other and prepare you to create a diversified portfolio.

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Source-

1 ? Retrieved from Seeking Alpha, ?Growth vs. Value Investing?

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