By Bruce Buerkle, CFA, Vice President and Manager, Securities Research Support
Do you know what your investment style is? If you’re like most investors, you probably haven’t given it much thought. If you’re unsure or new to investing, gaining a basic understanding of two popular investment strategies today — known as growth investing and value investing — can be helpful.
Keep in mind that when you diversify a portfolio, you generally have a mix of cash, bonds and stocks that are suitable for your individual investment objective and risk orientation. In addition, you make investment selections based on your time horizon, comfort level with different investing tools, income and liquidity needs. Your investment approach is tailored to your unique needs and so investment plans can be quite varied.
Simply put, a “growth” investor focuses on industries and companies which offer the opportunity for above-average revenue and earnings growth compared to the overall market or its peers. A “value” investor focuses on industries and companies that are considered to be undervalued based on forward-looking fundamentals. Let’s take a closer look:
While a growth investor carefully considers a company’s income statement and balance sheet, the ability to produce increased earnings over the long-term is tantamount. The investor studies an industry or company’s revenue and earnings trends relative to others within the same industry, and makes a determination whether its revenue and earnings will show consistent growth going forward. The growth investor looks for companies that may grow faster than its peers and the economy as a whole. Growth companies tend to pay lower dividends, opting instead to reinvest the funds into their businesses. A track record of consistent earnings growth can lead to above-average return on equity.
Investors who place a portion of their portfolio in growth stocks feel that earnings and revenue growth can protect a company and its stock during a period of economic weakness and help to insulate a portfolio during future economic uncertainty. However, it is important to remember that even companies which meet these criteria can be subject to economic downturns, which could cause their stock values to decline. As a result, your shares, when sold, may be worth more or less than your original investment.
A value investor seeks stocks that appear to be currently undervalued based on longer-term fundamentals. A number of tools can be used to evaluate these stocks.
The most commonly used tool centers on valuation multiples, particularly a stock’s price/earnings (P/E) ratio. This is calculated by taking a stock’s current price and dividing it by its earnings per share (EPS). Many investors use the EPS figure for the full current year and also perform the calculation using a 12-month forward estimate. To a value investor, a stock with a forward-looking P/E near the mid-point of the range over the past five years or lower would be considered a value stock, and possibly a suitable investment.
Another method to use is relative valuation — how the stock is measured relative to other companies within the same industry group. For example, a company with a P/E multiple of 20 might appear to be high. However, if other companies within the same sector are trading at a P/E of 25 or higher, it might be an investment to consider.
In using a value investment approach, the portfolio might get a boost if a company’s shares are trading at a price lower than what they are considered to be worth using relative P/E multiples. Value stocks may limit the downside risk if a company’s stock price is lower than would be the case if the stock price were trading near the average longer-term P/E multiple for that company. Value investors could also enjoy the higher dividend payouts often associated with value stocks.
As with growth investing, selecting stocks based on value investing methodologies will not guarantee results. Stocks with attractive P/E ratios fluctuate and so the holding may be worth more or less when you sell it than when you bought it.
Whether you are a growth investor or value investor, or prefer a combination of both styles, these methodologies can help you evaluate your investment portfolio in light of your goals, investment objective and risk orientation. You may also want to consider meeting with your financial professional for assistance in making these evaluations and for additional ideas.