Stock Market Education… Growth vs Value

Investors come in all shapes and sizes, and there is no ‘one’ investor profile that has proven successful. Two fundamental styles of stock picking that you have no doubt heard of are “growth” and “value”. Let’s have a look at how they differ and who they might be suitable for.


Investing for “Growth”

Growth stocks are companies that are seen to have the potential to outperform over a long period of time due to their future potential. As an investor, that means tuning your antennae to home in on companies that are growing. If you’re time poor, one of the quickest ways to spot these is to get a list of stocks with high PEs (Price to earnings ratios – there are other ratios you could focus on too).

Yes, it runs against all financial theory to buy stocks that look expensive, but there is a stockmarket hypothesis that says that if you buy ten “most expensive” stocks (the stocks with the highest PEs) and hold them for a year you will make more money than buying the ten “cheapest” stocks (with the lowest PEs).

It is a rather simplified reiteration of the principle behind trend trading, buying what everyone else is buying. Basically high PE stocks are stocks the market has identified as high growth stocks and for the average mug punter that is as good a filter as you might find without analyzing the annual reports and industry trends for yourself (between packing the kids school lunches). The bet you take is that these already expensive-looking companies will continue to grow. For that to happen you have to have faith in the principle of something we might call “underforecasting”.

Underforecasting is the assumption that growth is never forecast in totality from beginning to end in one hit, but creeps up on analysts and investors bit by bit. When a cycle starts (the mining boom for instance) analysts don’t leap to the end of the whole cycle and declare 20 years of higher iron ore and coal prices and factor those in immediately, they do it incrementally instead, upgrading as they go along, as reality unfolds. Because of that forecasts in an authentic cycle are by definition always behind the curve until the cycle peaks at which point they momentarily (like a stopped clock) are spot-on, before resuming another behind the curve forecasting profile in the decline. So the game, like trading a share price trend, is about trading the upgrade cycle, and success relies on spotting the cycle of upgrades has started and getting in before the end.

But spotting stocks that are in an upgrade cycle is a bit hard for the average stay at home punter, so suffice it to say, when you hear about a stock being upgraded, or read about a growth industry, go and have a look at what stocks there are and whether there is a trend of upgrades developing. For example, Webjet had constant profit upgrades during and after the GFC and outperformed constantly.

But of course with every silver lining comes a cloud. What goes up like a rocket can come down like a rocket and woe betide any growth stock that fails to live up to its high expectations. Set a stock up on a PE pedestal and you put it in danger. If a company ever disappoints on its growth assumptions you have to move fast. This is a high risk, high vigilance, bull market suited strategy for stock pickers. It is not set and forget. It is not for income.


Investing for “Value”

“the Warren Buffett Way”

Value stocks are companies that are seen to currently be trading below their intrinsic value, meaning they should provide outperformance as they bridge the gap to what they are “really worth”.

Value investing requires patience. A lot of it.

Most of us don’t have it. Most of us can’t shut our eyes to the volatility in the stock market. Most of us are incapable of fulfilling the sentiment behind those million ‘value investment’ quotes that sound so good but are just so impractical because most of us can’t afford another global financial crisis, most of us are on the ‘edge’ of our financial tolerance already and there is not an individual amongst us whose faith in assessed value in the long term would not crack if the edge of our financial envelope approached in the short term. We are too financially finely tuned.

The essential qualities of successful participation in value investing are time and money. You have to be wealthy because you cannot play patience with money destined for school fees and a mortgage and you have to have time, to wait for the market to spot something that you think you’ve seen but it may never see.

On top of all that, one of the fatal flaws with a complex assessment of value is that you could be wrong. An assessment of value involves a myriad of facts that might change and assumptions that may not be fulfilled. Only many, many years of dedication and experience can narrow the odds. You cannot count how many value investors identify value in companies that will go bust. It’s because the companies lie and the assumptions are wrong. How can you know that looking at financials in your study?

But what about Warren Buffett? The financial world is inundated by Buffettisms. There is hardly an adviser or investment product that does not claim empathy with his investment style. But the truth is there is only one Warren Buffett and only one person in the world that has his skill, patience, money, well-earned advantages and dedication to the task.

And for the rest of us? To think we can assess a profit and loss account between holding down a job and balancing the day-to-day demands of life is delusional, as is the marketing of the idea that someone who is not Warren Buffett can emulate him and his success on our behalf. If it was possible to imitate Warren Buffett and transplant Warren Buffett’s judgment into another fund manager, would we not know about it? Wouldn’t that fund be the highest returning fund in the market? And wouldn’t we all be invested and be billionaires?

We’ve killed the dream without telling you the good bits. The good bits are that if you do have the time, you do learn the skills and you do have the ‘financial patience’ then value investing has integrity. It is also one of the few approaches that does not offer some tempting but unrealistic shortcut. At its worst, it is a great filter for identifying bad stocks. At its best, it is a disciplined structure for stock assessment that works. If you have the time, money and skills, and you can do it, might just knock the socks off any other.