Value Vs Growth Investing
Two of the most common investment strategies are growth investing and value investing.Value investing is concerned with trying to find good quality stocks (and other assets) that are at the time cheaply priced.
Some indications of value are a low price earnings ratio (relative to sector), a healthy interest cover (earnings before interest and tax divided by net interest payments), eg 3 or more, and a conservative dividend payout ratio (dividend per share divided by earnings per share), eg 70% or less, and a decent inventory of tangible assets.
Of course it is always necessary to examine WHY a stock should be trading apparently cheaply. Is it truly on the way down and out? Or has it just temporarily fallen out of favor with good prospects of a turnaround? It’s worth remembering that markets often overreact, especially to bad news, before rebounding. So just after there’s been a tumble can be a good time to buy.
Value investing inevitably means taking a contrarian approach, ie going in the opposite direction to the crowd, and as such requires a degree of nerve.
By contrast, growth investing is concerned with finding which of today’s acorns will become tomorrow’s oaks. These are small stocks that you believe will get big.
Typically growth stocks have high price earnings ratio and a low (even zero) dividend yield. The classic example of modern times is the dotcom boom and bust, where people were throwing dollars at just about any Internet business idea, however vague. Good profits were made by those who got in and out quick, but once the market came to its senses and realised the degree to which many stocks were overvalued many more took big losses.
Academic research indicates value investing is preferable, eg Louis K. C. Chan and Josef Lakonishok concluded in Value and Growth Investing: A Review and Update (July 2002) that “the evidence suggests that, even after taking into account the experience of the late 1990s, value investing generates superior returns.” Warren Buffett, the world’s most succesful investor, is primarily a value investor.
Johnny Finnis is editor of personalmoneymanagement101.com, a simple and unbiased introduction to finance and investment for ordinary people to make the most of their money. Have your say on our blog
Tags: growth investing, value investing