Value investing vs growth investing. Which one is better? Should you be a value investor or a growth investor? With a million questions and different answers, you’re no further ahead with your decision than when you started. Even though the end goal of both styles belongs to the same school of thought – to make money, they employ polar opposite criteria for selecting investments. So, let’s review growth vs. value investing and how they square up on today’s Bullish Bear blog.
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What Is Value Investing vs Growth Investing?
Both growth and value investing form a dichotomy within the fundamental score of investing.
On the one hand, growth investing is the fast and furious approach that has been particularly popular and successful over the last few years.
On the other hand, value investing, made popular by Warren Buffett, employs a slow and steady approach. What’s the difference between value investing and growth investing? We can generally categorize these investing strategies based on three underlying characteristics.
Growth of the Underlying Company
Regarding growth investing, the primary focus is how quickly the company’s revenues and profits increase yearly.
So, naturally, growth investors are trying to invest in companies growing faster than the market.
Intuitively, this makes sense as one wants above-average returns, something that has the potential to take the market by storm and, in turn, make you incredibly wealthy.
You’re looking for the diamond in the rough, the next “big” thing. But unfortunately, many young and somewhat inexperienced “growth” investors can be accused of having shiny object syndrome.
Generally, investors in this category look for growth of at least 20%, which you don’t commonly find in well-established companies like Amazon, Google, and Tesla.
However, with the wild ride the market is on now, we’re seeing extraordinary growth among well-established companies despite their vast size.
Value Investing Is Slow and Steady
On the other hand, value investing isn’t about the shiny object or investing in the next best thing. Do you recall the fable of the tortoise and the Hare from your childhood?
A Tortoise and a Hare decide to race. The Hare is so confident in the lead that he naps while the tortoise keeps going to win.
Think of value investors as the tortoise. The tortoise isn’t looking for the next big thing or breakthrough promising to change the world. Instead, they’d rather put their money in the “snooze” or stable companies. Ultimately, while the Hare is napping, they keep going, waiting for their boring company to mature.
Sometimes, in the investing game, slow and steady wins the race.
Interestingly enough, sometimes, these companies even decline. But, since they’re in it for the long haul, growth investors stay in their positions for the most part. It’s not that growth investors don’t look for growth in their positions; their criteria for selecting stocks are different.
Stock Valuation
As the title implies, value investing is about being a bargain hunter. Who doesn’t want to find the diamond in the rough, paying $.95 on the dollar for your position?
The goal is to buy stocks with solid fundamentals currently selling for less than they should be. The investor will profit when the stock price returns to its fair value.
It’s common for investors to focus on more mature companies currently favoring the market because of some temporary headwind. However, some investors will put money in decline, or even bank accounts, if they believe they get more money back than they put in.
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Determining Intrinsic Value
A straightforward way to determine if one should employ the value or growth approach to a stock is to look at its intrinsic value. Of course, we have many different ways to determine intrinsic value. But, one easy way is to look at the PE or Price-to-earnings multiple.
The PE Ratio can be viewed as the number of years it takes for the company to earn back the price it paid for the stock. For example, if a company earns $2 a share per year and trades the stock at $30, the PE Ratio is 15.
Therefore, it takes 15 years for the company to earn back the $30 you paid for its stock, assuming the earnings stay constant over the next 15 years.
PE Ratio
A stock’s PE ratio is calculated by dividing its share price by its annual earnings per share. It shows an investor how much they’re paying for a dollar of annual profit.
A higher PE ratio means that investors are paying more for each unit of net income, making it more expensive to purchase than a stock with a lower P/E ratio.
For those in the investing game, you’ll already know other multiples you can use – like price to book value or even EBITDA. But, for simplicity’s sake, I will stick with PE.
People looking to invest in a specific industry can easily see which companies are the cheapest. Now, let’s turn to a real-life example to illustrate. Let’s say I want to invest in a pet grooming company.
After endless searching, I find one trading with a PE multiple five times. When I look at similar companies in the industry, they’re trading at a PE multiple of 10 times that of the company. It appears that I have found myself a bargain.
Or have I?
Upon further research, I find that the company is out of favor with the stock market, something about a lawsuit. However, my research shows that the company has a good management team and strong fundamentals.
For these reasons, I believe, in time, that the company will get back to a ten times multiple. Thus, I am going to invest. And since it’s such a bargain, my risk is lower than investing in the ten times multiple competition.
Word of Warning
Don’t just buy stocks or things, for that matter, because they’re cheap. They could be cheap for a reason. Please do your due diligence and put the time in to determine why it’s on sale. You want to ensure it will perform well over time.
Growth Stocks & PE Ratio
On the other hand, growth stocks tend to have pretty high P/E ratios. This may surprise you, but some trade at multiples as high as 30 to 40 times or even 100.
But sometimes, this multiple doesn’t apply because they don’t have the earnings to back up the valuation. In addition, because these companies report higher-than-average growth, they tend to draw much attention and buyer demand. Consequently, it’s this demand that leads to higher valuations and prices.
As a result, it is harder to earn a return because you pay a premium for the stock. However, growth investors will pay this price if they believe the growth of the stock is worth it.
Is a PE Multiple of 30 Expensive?
Imagine a growth investor who finds a tech company trading at a PE multiple 30 times. Is this overpriced? It might not be if they think the underlying company will double its operations in the next few years.
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Value Investing vs Growth Investing With Volatility
The final characteristic differentiating value vs. growth investing is the measure of volatility. Volatility is how much the stock’s price fluctuates. It should come as no surprise that younger companies with higher valuations will have large swings in price. As a result, their stock prices tend to jump around more than more stable-value stocks.
To illustrate volatility in growth stocks, think of price like a roller coaster. In one year, a growth stock may experience a rise of 30%, only to fall 40% the next and then rise 60% the next.
Differing from growth stocks, a value stock will often be more tedious. Think tortoise; perhaps it’s a consistent return of 8% annually.
As you would imagine, each investing style exposes investors to several different advantages and weaknesses.
Pros and Cons of Growth Investing
This is pretty obvious, but the main pro is the potential for higher returns. With stories of people becoming incredibly wealthy overnight, one can easily be swayed into the world of growth investing.
However, this approach tends to be a bit riskier. Take, for example, the scenario where you pay 30 times more for a company experiencing 40% growth for a year. What if it only reports a measly 5% growth the next? You may find yourself in a sinking ship, holding the bag on a crappy stock.
“The race is not always to the swift.”
Pros and Cons of Value Investing
Unquestionably, the major pro of value investing is the lack of risk. One often doesn’t have to worry about drastic price changes with low volatility. Or fear their investment may become worthwhile. However, it can take a lot of time for the value in stock to surface. What if it takes 20 years for your investment to realize its value?
Like looking for the diamond in the rough, value investors can fall victim to the value chop’s phoneme. In this scenario, they focus too heavily on buying cheap stocks and end up with crappy positions that are only getting cheaper.
Final Thoughts
I don’t think you should have a mutually exclusive approach when investing. I apply both methods; why limit yourself? I’m in it for the long game with my value stocks. However, I don’t mind throwing a few dollars down if a shiny new object comes into sight. You never know when you’ll find the diamond in the rough.
