Stock investing is an important engine of growth in your portfolio, but deciding on an investing strategy and particular stocks can be challenging. When designing a diversified portfolio that minimizes risk, it can help to think of stocks as falling into one of two categories: growth stocks and value stocks.
Both growth and value stocks can be important components of your portfolio, but they carry different forms of risk and require different investing approaches.
Investing for Value
Value investors look for bargains. That is, they attempt to find stocks that are trading below the value of the companies they represent. But, a value stock investment may take longer to pay off, and there’s always the chance that the market has indeed priced the stock accurately, leaving little potential for gains. Value stocks are more likely to pay dividends.
If investors consider a stock to be underpriced, it’s an opportunity to buy. If they consider it overpriced, it’s an opportunity to sell. Once they purchase a stock, value investors seek to ride the price upward as the security returns to its “fair market” price – selling it when this price objective is reached.
Most value investors use detailed analysis to identify stocks that may be undervalued. They’ll examine the company’s balance sheet, financial statements, and cash flow statements to get a clear picture of its assets, liabilities, revenues, and expenses.
One of the key tools value investors use is financial ratios. For example, to determine a company’s book value, a value analyst would subtract the company’s liabilities from its assets. This book value can then be divided by the number of outstanding shares to determine the book-value-per-share – a ratio that would then be compared with the book-value-per-share of other companies in the same industry or to the overall market.
Investing for Growth
Growth investors are using today’s information to identify tomorrow’s strongest stocks. They’re looking for “winners” – stocks of companies within industries that are expected to experience substantial growth. They seek companies in a position to generate revenues or earnings greater than what the market expects.
When growth investors find a promising stock, they buy it, even if it has already experienced rapid price appreciation, in the hope that its price will continue to rise as the company grows and attracts more investors. These stocks typically represent companies with a history of above-average gains and an expectation of continuing to deliver high levels of profit growth.
Where value investors use analysis, growth investors use criteria. Growth investors are more concerned about whether a company is exhibiting behavior that suggests it will be one of tomorrow’s leaders; they are less focused on the value of the underlying company.
For example, growth investors may favor companies with a sustainable competitive advantage that are expected to experience rapid revenue growth, that are effective at containing cost, and that have an experienced management team in place.
Value and growth investing are opposing strategies. A stock prized by a value investor might be considered worthless by a growth investor, and vice versa. Which is right? A close review of your personal situation can help determine which strategy may be right for you.
Which one should you choose?
The styles of growth and value investing complement each other, and investing in growth stocks and value stocks is one way to add diversity to your portfolio. Some investors, however, favor one approach or the other. In that case, there are some factors to consider.
Growth stocks tend to be more volatile than value stocks, with more price fluctuations of greater magnitude. For this reason, growth stocks are inherently riskier than value stocks and may be better suited for risk-tolerant investors with a longer time horizon.
Value stocks tend to offer less growth potential in the short term, but could be safer investments in the long run, making this strategy a better fit for more risk-averse investors.
Choosing between these two strategies may also come down to economic conditions. Some experts say growth stocks perform better when interest rates are falling and company profits are rising, and value stocks do better during an early economic recovery period.
It bears repeating that not all so-called growth stocks end up growing, and not all so-called value stocks deliver value. Once you’ve settled on an approach according to your personal preferences, investment timeline, risk tolerance, and financial goals, you still have to do research on the stocks themselves to decide whether you want them in your portfolio.
Get Insights from a Financial Professional
Are you unsure how you would like to balance the stocks you have in your investment portfolio? Book a time to have a conversation with one of the financial professionals at Emerj360.
