Value investing selects stocks that are priced low relative to measures of worth, such as earnings, sales, assets and equity. Common measures of value include low price-earnings ratios, low price-to-book ratios, and high dividend yields. This is not to say that all firms with lower price-earnings ratios or high dividend yields are good values. To be a good value, they must be able to show some potential. Many stocks with low price-earnings ratios have little potential and deserve their low multiples.
As a general rule of thumb, approaches that focus primarily on value tend to be less volatile than the pure growth approaches, and they tend to have less portfolio turnover. Typically, they do not invest in smaller firms, preferring to focus on companies that are more mature and mid-sized or larger in terms of market capitalization. Historical earnings growth rates are rarely much above the market average, and the prices of the selected stocks do not tend to have momentum relative to the market. Value approaches tend to outperform other approaches during bear markets, but they can fall behind during bull markets, particularly during the strongest portion.
The growth investment style is concerned with selecting stocks that will exhibit above-average and increasing growth. Growth investors look for industries and companies that are in the aggressive growth and growth stages of their life cycle—a period associated with rapid and increasing growth rates in sales and earnings with still-reasonable profit margins.
Minimally, growth companies are growing above the rate of the overall economy. Practically speaking, however, the benchmark for being classified as a growth stock is a 20% annual growth rate in earnings per share. Unless you are looking at a cyclical company coming out of a slump, growth rates this high generally require capital spending to maintain expansion. Growth stocks will therefore retain most of their earnings. Investors looking for high-dividend-yielding stocks will generally look for firms late in the growth stage or in the mature stage.
One weakness with growth stocks, especially those in the aggressive growth stages, is that internal cash flow may not be able to support growth and, thus, more capital by issuing additional shares will be required. This may have the effect of diluting the existing ownership of shareholders.
Stocks with high growth and good prospects attract a great deal of attention. Price tends to be bid up with high anticipation. High expectations relative to current levels of earnings lead to high price-earnings ratios (price divided by earnings per share). It is not uncommon to see highly touted growth stocks with price-earnings multiples two to four times the market. As long as a firm maintains its earnings per share momentum and exceeds the growth expectations of the market, its stock price can be expected to increase tremendously. Growth stocks, however, tend to be volatile. A small deviation from market expectations during a quarterly earnings announcement can send the price flying in either direction. Institutional investors own a large percentage of growth stocks and when they all try to head for the exit door the price can tumble.
Growth
strategies want to buy growth, period. Their focus is on companies that are
rapidly expanding their sales and earnings. Often, these stocks are already
on the move, with prices typically moving up faster than the market. The approach
tends to be more volatile-prices can move up or down substantially, with small
changes in expectations-and it tends to perform better on a relative basis late
in the bull market or when the economy is slightly down. For these reasons,
it requires close monitoring.