As a client of Financial Synergies, you’ve undoubtedly heard us use the terms “growth” and “value”; they are even included in the names of some of our funds, and are strategies we utilize in your portfolios.
Growth and Value are the two distinct and dominant styles of stock investing, and on the surface they appear to be contradictory in philosophy. There is no absolute, clear-cut definition of the growth or value styles because investors will have their own variations of each. I’ll attempt to broadly define both styles and explain why they are not necessarily diametrically opposed.
In general, growth investors seek out stocks of companies that have demonstrated better-than-average gains in earnings in recent years and are expected to continue delivering high levels of profit growth in the years ahead. These investors are not usually overly concerned with the current price of the stock, even though growth companies are often much more expensive than the overall market, and in comparison to their intrinsic value. Growth investors are willing to “pay up” for the stock, with the belief that it will continue reaching new highs in the future.
Growth stocks typically look expensive when analyzed on a fundamental basis with valuation ratios such as price-to-earnings, or price-to-book value. Companies are often newer entities in fast-paced industries, including information technology or biotechnology. These companies rarely pay a dividend; the excess cash is put back into the business to hopefully fund future earnings growth.
Growth stocks tend to outperform in bull markets, particularly in the late stages of the cycle as prices go up. Likewise, there is a certain degree of risk if the company experiences any negative press, reports disappointing earnings, or if the stock market generally declines. In these situations, growth stocks could take a harder hit. In other words, high flying stocks have much farther to fall than less popular ones.
The simplest way to explain value investing is to look at it as though you were buying a business, itself, not just shares of a company. Value investors emphasize the intrinsic value of assets, current and future profits, and strive to purchase the stock of the company for less than that value. If their fundamental analysis is accurate, the intrinsic value of the stock will eventually be reflected in the stock price and they will profit handsomely.
This method of buying the company for less than it’s worth provides the value investor with a “margin of safety”, should their calculations prove to be incorrect. Benjamin Graham pioneered the value investing philosophy, and his disciple, Warren Buffett, perfected it. These are two of the greatest value investors in history.
Value stocks tend to outperform after market declines; typically, they don’t fall as sharply as growth stocks and can be picked up at a lesser price point.
You can’t have one without the other…
One of the biggest misconceptions about modern value investors is that they aren’t concerned with growth. So value stocks aren’t supposed to grow? It doesn’t seem rational for any investor to buy a company with no expectation of future growth. Sure, the company might pay a dividend, but no successful value investor is going to buy a stock simply because it’s cheap and they have no expectation that it will grow in the future. Most of the time stocks are cheap for a reason, which doesn’t necessarily represent a good value.
The art and science of value investing involves calculating the intrinsic value of the company based on fundamental analysis, and estimating its future growth potential and then buying it for a price less than that estimated value.
I’ve made the case that you can’t find great value without some expectation of future growth. Does a growth investor perceive value in his purchase of a high-priced stock, or is he simply buying it because it’s expensive? That wouldn’t make much sense. The assumption is that the stock will continue to appreciate in price, providing the growth investor with a nice return.
Value investors are concerned with growth, and growth investors are concerned with value. They just go about choosing investments a little differently.
Warren Buffett famously said that, contrary to popular belief, “Growth and value investing are joined at the hip. Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
We think both strategies belong in a diversified portfolio.
–Mike Minter, CFP®, CFS®