Investing Basics: Growth or value investing?

Whatever style an investor adopts, the goal is always to identify and buy an asset in the hope and expectation that its price will increase; whilst the ambition may be simple enough, its achievement may be altogether trickier – how do you judge whether your investments are positioned to get the best possible return? – asks Christian Leeming.

So, what are growth and income investing, and what’s the difference?

According to Investopedia:  ‘Growth and value are two fundamental approaches, or styles, in stock and stock mutual fund investing. Growth investors seek companies that offer strong earnings growth while value investors seek stocks that appear to be undervalued in the marketplace’

So, in addressing the question posed in the introduction, growth investors would seek to buy companies that are growing their revenue, profits or cash flow at an above-average rate, whilst value investors will be looking under the bonnet, hoping to unearth stocks that the market has undervalued.

In truth, adopting an investment style is rarely binary – herein we also look at ‘growth at reasonable price’ (GARP) investing; investing styles are not mutually exclusive, real life investors may adopt either a growth or value approach according to individual circumstances.
 

What Is Growth Investing?

Growth investors aim to buy young, early stage companies seeing rapid growth in profits, revenue or cash flow; they prefer capital appreciation, or sustained growth in the market value of their investments, rather than the steady streams of dividends sought by income investors.

High profile growth companies in the States include Tesla, Amazon and Facebook, and companies like Roku and Zoom are getting plenty of attention. However, it is not just cutting edge tech companies that are on the up; Beyond Meat produces 100% plant-based meat-substitute products – its shares are up 116% on its 2019 IPO price.

UK equity markets are rather unloved at the moment – so potentially a happy hunting ground for value investors – but Motley Fool currently offers up Fevertree, which has had a good pandemic, game developer Frontier Development and Clipper Logistics as must have growth stocks.

Key to understanding growth investing is to understand the life cycle of companies. In the early days, a new company may grow quickly, generating rapid gains in revenue and profits; at this stage a company typically reinvests profits back into the business to drive further growth, rather than paying out dividends.

As the company, and the markets within which it operates, begin to mature, growth in revenue and profit slows; when it is fully mature, growth slows further. At this point in the cycle, companies tend to distribute profits to investors in the form of dividends as investment opportunities in their markets diminish.
 

Growth at a Reasonable Price (GARP) Investing

When analyzed with standard valuation metrics, such as the price-to-earnings (P/E) ratio, growth companies often appear expensive; in some cases, astronomically so – in mid-September 2020 growth investors’ darling Amazon had an astonishing P/E ratio of 128.

Growth investors look beyond current expensive valuations to the even greater expected growth of  companies in the future; whether such a ‘growth at any price’ approach to investing is sustainable is debatable, so some investors, including famed investor Peter Lynch, popularised a strategy that looks for reasonably priced growth companies called GARP investing.

GARP investors look to balance growth against high valuations by seeking growth companies that are priced in line with their intrinsic value; Investopedia – ‘Intrinsic value is a measure of what an asset is worth. This measure is arrived at by means of an objective calculation or complex financial model, rather than using the currently trading market price of that asset.

The key challenge for growth investors is to forecast a company’s growth prospects; predicting future growth with any degree of certainty for younger companies in fast-changing industries, can be very difficult. And even if they get it right, how much should they reasonably pay for that growth?

GARP investors use a ‘PEG’ ratio to determine if a company is reasonably priced given its growth prospects, which is calculated by dividing the P/E ratio by the expected growth rate of a company.

A ratio of one or less indicates that the stock is reasonably priced; above one says the stock is too expensive.

For example – Acme Media trading at £100 per share, with earnings of £10 per share and expected growth rate of 20%; PEG ratio = 0.50 (£100 / £10 / 20) and considered reasonably priced for a GARP investor.

Acme Industrials trading at £300 per share, with the same earnings of £10 and expected growth rate of 20% would be considered too expensive by a GARP investor with a PEG ratio of 1.5 (£300 / £10 / 20).
 

Growth vs Value Investing

Growth investors want everything turbo-charged, whereas value investing targets older companies priced below their intrinsic value.

Over the long term, value investing has outperformed growth investing, although growth investing has been shown to outperform value investing more recently.

The Financial Times recently noted that growth investing had outperformed value investing over the last 25 years stating that since 1995, value mutual funds have returned 624%, while growth mutual funds have returned 1,072%.

Vanguard’s index funds show a similar trend; the Vanguard Value Index Fund has returned 6.18% annually since its inception in 2000, the Vanguard Growth Index Fund has returned 8.10% annually over the same time period.
 

The Future of Growth Investing

Neither strategy has outlasted the other indefinitely; some believe that the recent trend favouring growth investing will run out of puff, with value stocks once again outperforming growth strategies.

However, macro economic trends currently favour growth investing; historically low interest rates give easy access to cheap capital – the lifeblood of fast-growing companies – although they could be adversely affected if money were to become more expensive.

Equally, the pandemic may favour technology companies in growth mode; more shoppers have gone online and as companies embrace remote working, technology demands increase to sustain this shift.

Forecasts of the end of the ‘tech bubble’ have filled countless column inches, but there has been a seemingly inexorable rise of tech stocks during the crisis; however, despite the current purple patch for growth stocks, history says that nothing lasts forever.

How and when the current trend will end is unknown; the bursting of the dot-com bubble was sudden and caused severe financial pain for many investors, although if life really has changed forever, maybe the current valuations for firms supporting the ‘new-normal’ may not turn out to be quite so fanciful as those in the early naughties which saw the Nasdaq index fall by 76.81%

 

A Hybrid Strategy

There’s no need to exclusively pursue either a growth or a value investing strategy; a better choice could be to adopt a hybrid investing strategy by buying companies that fall into both value and growth categories; this could be as easy as investing in an index tracking fund.

Returns from a hybrid approach typically lag either a growth or value strategy in the short term, depending on which is outperforming the other; thus it can be psychologically difficult to stick to a hybrid approach when more money is being made elsewhere; however, over time such an approach can outperform an investor switching between growth and value in an attempt to time the market.
 

Conclusion

Growth investors seek to take maximum advantage of companies early in their business cycle; by targeting companies in high-growth industries they can benefit as companies rapidly grow their revenues, earnings and cash flow.

However, a growth strategy may not be a silver bullet; growth companies can be very expensive and in addition, abrupt shifts in market sentiment can send growth company values falling as they did during the dot-com crash.

Furthermore, according to FE Trustnet – ‘Conditions are Perfect for Value Investing’ – you pays your money and takes your choice.

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