Are You a Growth Investor or a Value Investor?
Which would you rather invest in? Expensive shares of a company with excellent growth prospects, or cheap shares of a stable, mature company?
This is a debate investors have been engaged in for centuries!
Growth investors must typically pay a premium price to own shares of a great growth company. But they rationalize the higher price because they believe the company will “grow into” the premium price they paid.
Value investors, on the other hand, look for opportunities to buy shares at a discount. The goal is to find stocks that have fallen out of favor and can be purchased at a cheap price. Value investors believe that over time shares will return to a “fair” price, giving them an attractive return.
You don’t have to choose one style of investing or the other. Many successful investors have both growth stocks and value stocks in their portfolio. But it’s important to understand the basics of each style of investing.
Editor’s Note: This is part II in our multi-part series on fundamental investment principles. See Also:
Stay tuned for our next installments. You can also email me (Zach@ZachScheidt.com) to let me know what fundamental questions you have about investing.
Value Investing: The Classic “Buy Low, Sell High” Approach
In our last “fundamental investing” installment, we talked about the different ways to value shares of stock. One of the most popular measures is the price / earnings (or PE) ratio. A lower PE means you’re paying less for every dollar of earnings a company generates.
Value investors look for stocks with low PE ratios. In other words, these investors want to get more company profits for every dollar they spend to own shares of that company.
When buying stocks with a low PE ratio, it’s important to understand why the stock is trading at a discount.
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There are many different reasons a stock could be trading for a discount. Here are a few reasons that I often see when doing my research:
- The company is not well known (so very few investors are buying shares).
- Investors are worried about risk (such as a pending lawsuit or new competitor).
- The company is mature and unlikely to grow.
- There has been a negative event (such as a lost contract or a damaged facility).
Value stocks are usually trading at a cheap price because there is something wrong with the investment.
So if you’re going to buy shares of a stock for a discount, you should think hard about why the stock is cheap — and more importantly what you expect to happen to cause the stock to trade back higher to a “normal” price.
Many legendary value investors such as Warren Buffet have made a great living by purchasing shares at deep discount. Value investing is a great way to grow your retirement, provided you do your research and you wait patiently for your shares to move higher.
Growth Investing: Paying Up For Future Results
Growth investors typically pay a much higher price (compared to earnings) for their shares of stock. This is quite different than a value investor who only buys stocks at a discount price.
It may sound counter intuitive to buy shares at a premium price. But if you believe that a company will grow profits for years to come, it makes sense to pay a little more for these shares.
Growth investors live by the mantra: Buy high and sell higher.
This type of investing is the most profitable when the underlying economy is growing, and when investors are optimistic.
Growth stocks are often very exciting companies to be involved in, which is one reason why this style of investing is so popular. Well recognized names such as Facebook (FB), Netflix (NFLX) and Tesla Motors (TSLA) are good examples of current growth companies.
Growth investing tends to be a “high risk, high reward” approach.
Risk is high because of the premium price investors typically pay. If a company reports growth that is below expectations, the price could drop sharply. With less growth expected, investors will be less willing to pay a premium price. This risk can be devastating to investors with too much exposure to growth stocks.
The opposite side of this coin is that returns for growth stocks can be very strong. If a company grows faster than expected, investors will be willing to pay more of a premium… Often much more.
When I invest in growth stocks, I look carefully at the rate of growth analysts are expecting. It is often reasonable to pay a price / earnings ratio that is similar to the company’s profit growth rate.
In other words, for a company that is expected to grow earnings by 40%, I would often accept a 40 PE ratio.
Balancing Value and Growth Stocks For Your Retirement Account
I believe there is value in owning both growth and value stocks in your retirement account.
- Value stocks can give your portfolio stability with less risk. These stocks also typically pay attractive dividend yields.
- Growth stocks can help your portfolio grow quickly. These stocks can offer explosive returns when things are working well.
The key is to carefully balance both of these approaches, and to understand the merits and drawbacks of each.
In today’s market, I would suggest leaning more toward value stocks. That’s because we’ve had a long period where stocks have traded higher and we’re overdue for a pullback. There are some large risks to the market as well which we’ll discuss separately.
Owning value stocks should help to protect your wealth in the event that shares of stock pull back.
When stocks trade sharply lower, growth stocks often get hit much harder than value stocks. This is because investors become less optimistic on future growth opportunities for their favorite companies.
Be on the lookout for these periods. Bear markets often give investors great opportunities to pick up growth stocks at cheap prices. This isn’t usually a popular move (as most investors become pessimistic). But sometimes taking “the road less traveled” can be the most profitable path.
For more fundamental (and also advanced) investment content, be sure to check out my top ten list of investment books here. And stay tuned for more in our fundamental investment series coming soon.
Here’s to growing your income!