Value vs. Growth Investing: And the Winner is…

There are many investment strategies used by a myriad of both individual and professional investors. Some prefer the growth strategy while others prefer a value approach. While both good in their own regard, a combination of the two trumps them both, and here’s why.

Value Investing

The fundamental goal of value investing is, quite simply, to buy a stock when it is low and sell when it is high. Seems easy, right? Though it may seem like common sense, the vast majority of investors do not do this. Very few use this strategy effectively. Some of the greatest investors of all time, such as Warren Buffett and Benjamin Graham, used a value approach in their investing careers.

The primary characteristic of a value investor is that they love finding good deals. It might be best to think of them as shoppers who scour through the Sunday newspaper for coupons. This is exactly what they do, but instead of looking through the paper for good deals, they look through the universe of stocks. At any point in time, there are dozens of companies whose stock is depressed. There are many reasons for this to happen, such as disappointing quarterly results, unexpected charges, changes in leadership, boring products, etc. A value investor will weigh the drops in stock value with the news that caused it. If it appears to the investor that the market overreacted (as it almost always does), then he or she might pick up some of the shares at a discount and wait it out.

In addition, a value investor does not look for companies who have yet to prove their products. A great example of this is the biotechnology industry. Many of the smaller biotechnology firms don’t even make money at this stage, as they are still undergoing heavy research and development and clinical trials. A true value investor would never invest in a company that does not make money.

Value investors want to see that the company is making money and that the stock is cheap relative to the value of the company. There are many ways of determining this, but perhaps the most widely used method is to look at the price-to-earnings ratio (P/E) of the company. This ratio allows the investor to quickly determine the value of the stock relative to the amount of earnings generated by the company. The lower the ratio, the better the bargain the investor is getting. This isn’t true in all situations, of course, and must not be used as the sole measure for evaluating a stock. The point is that value investors seek quantifiable facts to determine whether a stock is undervalued or not. This, as value investors call it, is a “safety net.” If the company is undervalued to begin with, bad news or a market downturn will not affect the stock as much as a stock which is overvalued.

By using such quantifiable measurements, the value investor can safely stay away from using his or her emotions in stock selection. How many times have you received a “hot tip” from someone who claims they know what they’re talking about and assure you of great returns? Value investors ignore “hot tips,” hype, and market hysteria.

Below, you will find a list of both the positive and negative aspects of value investing.

Pros:

• Reduces risk of under performing by choosing investments which have a built in “safety net”
• “Hot” stock tips, hype, and mass hysteria do not affect the decisions a value investor makes
• Produces steady, consistent gains that regularly outperform the S&P 500

Cons:

• The potential returns for value investing are smaller than those of growth investing

More often than not, those who choose the value approach consistently outperform the market. In the last 20 years, the S&P 500 has obtained compound annual returns of 13% per year. Also in the last 20 years, small-capitalization companies (smaller than 2 billion dollars) that were considered value obtained compound annual returns of 15%, better than all other types.

As discussed earlier, the most successful investor of all time, Warren Buffett, is a champion of value investing. His company, Berkshire Hathaway (NYSE: BRK-A), has been one of the top performing insurance companies of all time. Buffett’s personal success, as well as the success of Berkshire Hathaway, is a testament to the power of value investing.

Growth Investing

The fundamental goal of growth investing is to buy a stock no matter what its price is and sell it for more. As you have probably noticed by now, and as the data show, growth investing is much more akin to gambling than investing. Why, then, do the majority of investors use prefer growth over value? The answer is the same reason many gamble; there is a chance you can make a lot of money in a short period of time.

Let me give you an example. Remember in the late 1990’s when everyone was so enthusiastic over all the dot-com companies sprouting up everywhere? Those who were swept up in that were reacting to the mass hysteria that occurred and it led to the 2000-2002 crash that left many investors without their shirts. Let’s revisit some of the companies that growth investors invested in during the late 1990’s, as well as how bad things got in the early 2000’s.

Amazon (NasdaqGS: AMZN) shares, at their peak in 1999 were worth roughly $100 per share. In September of 2001, they were trading for roughly $6 per share. This represents a 94% drop in the price of the stock. If you had invested $10,000 when the stock was near its peak, as many growth investors did, you would have had only $600 remaining.

CMGI (NasdaqGS: CMGI) shares, at their peak in March 2000 were worth nearly $150 per share. In August of 2002, those same shares were worth a mere $0.31 per share. This is nearly a 100% loss of value. If you had invested $10,000 in March of 2000, you would have had a few cents leftover by August 2002.

Cisco (NasdaqGS: CSCO) shares, at their peak in March 2000 were worth $82 per share. In September of 2002, they were worth around $10 per share. They’ve gained some ground since then and are trading at around $30 per share. You’d still be down around 64% of your original investment.

The list goes on and on, but I think you get the picture. These examples represent an accurate, albeit exaggerated view of the issues involved with growth investing. When an investor decides to invest in a stock without determining the true value of the company, he or she is often in for a nasty surprise.

Growth investors fall victim to group-think and herd mentality often. Their strategy is fundamentally flawed in that the value of the company relative to the stock price is neglected. The dot-com crash of the early 2000’s caused a lot of investors, both individual and professional, to lose tremendous amounts of money. Many mutual fund managers and other “experts” found that the funds they had been selling to average investors were now worth nearly nothing. Even the popular investment personality Jim Cramer was caught with his hand in the cookie jar. Several of his investment funds lost everything. It takes an extremely unique, strong, and independent mind to resist group-think when investing.

Below, you will find a list of both the positive and negative aspects of growth investing.

Pros:

• Potential for incredible returns in a short period of time

Cons:

• Hot stock tips, rumors, hype, and market hysteria are not reliable sources of information to act upon
• Failure to relate the stock price to the company value leads to purchasing overvalued stocks
• Safety net is low or non-existent
• Market downturns hit growth stocks far harder than value stocks
• Potential for total loss

Those who choose the growth approach consistently under perform the market. In the last 20 years, the S&P 500 has obtained compound annual returns of 13% per year. Also in the last 20 years, small-capitalization companies (smaller than 2 billion dollars) that were considered growth obtained compound annual returns of 8.8%, worse than all other types and over 40% less that of value investment returns of 15%.

So what?

Value investing utilizes a strict methodology that is based on facts, not hype. Never forget that the majority of investors lose money because they did not control their emotions, a typical failing of most growth investors. What if you could combine the pros from each of the strategies and reduce as many of the cons as possible? I’ll tell you what would happen: you would achieve returns even better than 15% and likely breaching 20%. This can be done by combining both strategies into a value/growth blend approach.

Value/Growth Blend

The value/growth blend approach to investing requires the use of the valuation metrics described previously as well as a utilizing certain growth criteria. While most of the valuation metrics utilize hard facts, the growth aspect is much more difficult to understand. No one knows what will happen in the future. If someone says they do, run for the hills. If an investor views the world economy as a whole, though, he or she can get a pretty good sense of macro-economic trends likely to be significant in the next few years. This is not an exact science, and requires much research and a vast amount of economic knowledge. When performing this test, it becomes apparent that there are several industries that will most likely see prolonged growth in the next decade.

Freund Investing Managing Member Ryan Freund holds no position in any of the companies mentioned in this article. Freund Investing has a solid Disclosure Policy.

This article was printed on December 30th, 2007. It has since been updated.