The Hindu Business Line : Value <I>versus</I> growth strategies

It is difficult to adhere to either a pure value or pure growth strategy. Most of the investors employ a combination of value and growth investing styles seeking growth at a reasonable price.

Often we hear investment gurus talking about value-based investing while others fancy growth stocks. What exactly is value and growth investing?

Value investing is an approach to picking stocks that appear undervalued vis-à-vis their fundamentals. In other words, value investors buy stocks whose current market price is less than the intrinsic value of the company's business.

Intrinsic value is what the company is actually worth and reflects the value of both tangible and intangible assets. Value investors look at quantitative variables such as earnings, dividends, book value and cash flows and qualitative factors such as management bandwidth and competence, competitive advantage and corporate governance, among others, for determining the company's intrinsic worth. Typically, they look at stocks with high dividend yields, high book value or low price-to-earnings multiple or a mixture of all three. Their reasoning is based on the premise that markets are not very efficient and, hence, do not reflect the true value of stocks at all times. The market overreacts to good and bad news, causing sharp movements in prices that do not correspond with fundamentals of the company.

The defensive strategy

Value investors largely follow the bottom-up investing style that we talked about last week (Business Line, December 24). They focus on the inherent strengths/weaknesses of individual companies and as such market gyrations and macro-level changes do not matter to them. As value investors adopt a defensive strategy, the margin of safety (difference between the current market price and the intrinsic value) ensures that the downside risk to investment is limited. However, value investing should be applied with caution and is certainly not for the uninitiated. Everything that appears cheap may not be a good bargain. At times, the fall in a stock's price may be on account of impending events such as a change in industry dynamics that are not captured in its current financials. Investors who buy such a stock thinking it to be a value pick may end up with a dud.

Focus on growth potential

Growth investing, on the other hand, is contrary to value investing. Growth investors set store by the growth potential of the company. Unlike value investors, they do not base their decision on how a company's stock is priced in relation to its intrinsic worth. They place greater emphasis on the growth opportunities for a company, and may not mind paying a price for that.

Typically, this set of investors looks for fast growing companies or those in sunrise sectors (those in the early stages of growth). Their reasoning is that the growth in earnings would translate into improved stock prices. Returns for such a class of investors is mainly in the form of capital gains and not necessarily through dividends. This is because high-growth companies, by and large, re-invest their earnings for funding future growth and do not pay dividends.

Growth stocks are usually characterised by low dividend yields, high price-to-earnings ratio or high sales-to-market capitalisation ratio or a mix of all. For identifying stocks with high potential, growth investors look at key variables such as rate of growth in per share earnings over the last five-10 years, expected growth in earnings over the next five years or so, operating and net profit margins and business efficiency.

On a macro level, factors such as the stage in business cycle in which the industry operates, its relative attractiveness, and the positioning of the company in the competition matrix form part of the investment analysis. They then look at the current price and determine if it reflects the growth potential of the company's business.

High downside risk

As growth investing often involves taking exposure to companies that trade at high valuation levels, the downside risk is relatively high. Sometimes, owing to their unproven business models, these companies could be sensitive to changes in market movements and business cycles.

However, in practice, most of the investors employ a combination of value and growth investing styles or "growth at a reasonable price". Adopting such a practice helps you in identifying undervalued stocks and, at the same time, offers an opportunity to be part of high-growth companies, thus minimising the risk of your portfolio.

Please send suggestions and queries to younginvestor@thehindu.co.in, or The Research Bureau, The Hindu Business Line, 859-860, Anna Salai, Chennai-600002.