Growth Stocks vs. Value Stocks
Stocks (Equities) are a medium that allows an investor to have a share in the ownership of a company through purchase of a company’s stock. Equities are also described as representing an ownership in the assets and earnings of a company. These definitions, while not perfect, can give you a basic idea about what it means to own the stock of a company. Within the asset class of stocks there are a couple of main styles of stocks, and these are growth stocks and value stocks. In this article, we are going to be discussing some of the key characteristics of growth stocks and value stocks.
A growth stock is defined by Wikipedia as:
In finance, a growth stock is a stock of a company that generates substantial and sustainable positive cash flow and whose revenues and earnings are expected to increase at a faster rate than the average company within the same industry.
Now that we have a growth stock defined, let’s dive deeper into some of the broader characteristics of growth stocks and how they can be differentiated from other types of equities (stocks). Here are some of the basic characteristics:
- Growth stocks usually grow in excess of their peers
- Growth stocks typically pay no dividend, and invest all available cash back into the business
- Growth stocks are often valued when they are early stage companies
- Growth stocks usually have growth rates in earnings and revenue above 20%
- PEG ratios are commonly above 1
- Companies operate in large target markets & fast growing industries
- Increasing Valuations - Valuations for growth stocks can be high with common P/E multiples in the high 20s and even higher. If a growth stock performs as expected, it is common for these high valuations to become even higher in the early phases of corporate development.
- Strong business model and wide competitive moat
- P/E ratios often high relative to peers and the market multiple. P/E ratios often over 20.
These are some of the characteristics that define growth stocks, but as we mentioned a growth stock is different than a value stock. Value investing is defined by Wikipedia as,
Value investing is an investment paradigm which generally involves buying securities that appear underpriced by some form of fundamental analysis…
Basically, a value stock is undervalued based on some views of the market and the company. What investors feel, is the stock should be valued higher, and it will soon return to a normalized valuation based on company fundamentals. Not all value stocks have major negative events that have caused them to be undervalued. In some cases, the market can develop a view of a company that has led it to be given a lower price multiple by the markets. Here are a few value investing characteristics:
- Value stocks are thought to be cheaply valued.
- Value stocks are often companies that are currently out of favor, or companies that are currently experiencing negative market perception which has caused the stock to be undervalued.
- PEG ratios are often below 1
- Value stocks often pay a dividend and are historically stable companies, that have temporarily been mispriced by the markets.
- Value stocks often trade at a lower price relative to their peers based on fundamentals.
- P/E ratio is often lower than peers and the market multiple. P/E ratios often less than 10.
- Slower growing
So, after seeing a few characteristics of each style of stock, we can start to make some comments about the two investment philosophies. The following comments relate to the mindset of an investor when making the initial investment decision. At the time of investment, a growth stock is performing in excess of its peers, while a value stock is often trailing its peers due to a negative market perception. Next, growth stocks are often in fast growing and cutting edge markets, while value stocks are typically in slower growing and more mature markets. Growth stocks are investing capital into future growth, while value companies are often paying larger dividends and essentially divesting capital. Paying higher dividends can have a negative perception of lower growth in the future, since the business is choosing to not reinvest the money back into the company. Companies paying higher dividends can also be the result of an extremely successful company, simply generating too much cash.
At Robert Bender & Associates we favor investing in growth stocks for our clients. Here are a few of the reasons why we lean toward growth stocks. We believe that it is always best to invest in companies that are thought to have a bright future, and companies for which the market has positive expectations. With a value stock, at the time of purchase, the stock is often out of favor, struggling with a low valuation, and there is slow growth. If the value company is able to turn things around and overcome the negative circumstances affecting the stock price, this turnaround may only lead to limited stock upside. Simply because the value stock has a turnaround, it does not mean that they will grow faster than their peers and in excess of the market. We would argue that if a value stock turns around their business, and obtains an expected market valuation, that this may be all of the upside for the company.
In contrast to a value stock, a growth stock on the other hand can sustain above average growth that lasts for years and even decades. A value stock is looking to regain a fair valuation, while a growth stock is looking for price appreciation of many multiples. While there is uncertainty with both value and growth stock investing, we feel it is in our clients best interest to invest in well run companies, growing in excess of the market, and are usually considered to be one of the top companies in their sector. We realize both styles of equity investing are void of guarantees of future performance, and both styles at times have periods of outperformance that can make either style appear attractive. At Robert Bender & Associates we prefer to invest with growing companies whose future is bright, and not into companies that are potentially suffering from lower valuation. One of the main challenges of the value investor, is to determine if the market was incorrect in ascribing a low multiple to the equity investment.
Over time, A Great Growth stock will Exhibit Value Characteristics
Let’s take Apple for example. We invested into Apple when it was clearly a growth stock. We first bought Apple when it was switching to the Intel chip inside the iMac computers. This investment was before the iPhone, iPad, iWatch, App Store, and iTunes, and we have owned the stock for over a decade in our growth portfolios. In the case of Apple, the company has gone from being a fast growing company, to a slightly less fast growing company and now they pay a dividend to their investors. Many value investment managers own Apple, and claim it is now a value stock because it is so cheaply valued and Apple pays a dividend. We have owned Apple through this perceived value stock transition, and while it may exhibit some characteristics of a value investment, we still view it as a growth stock at the time of this writing.
We have owned many stocks that were once clearly growth stocks, and eventually exhibited many traits that led others to view them as value stocks. Any time we have a small growth stock grow and mature into a large dividend paying value stock, this often means we’ve owned the stock for many years. At Robert Bender & Associates we employ a top down and bottom up fundamental analysis and apply our analysis to both markets and companies. Our analysis leads us to invest in what we view are top quality companies which should grow in excess of the markets. If you would like more information, please contact our office.
A Common Challenge for Individual Investors
As defined by Investopedia: A retail investor, also known as an individual investor, is a non-professional investor who buys and sells securities, mutual funds or exchange traded funds (ETFs) through traditional or online brokerage firms or savings accounts.
Behavioral biases are common triggers that can affect individual investors who manage their own money. Some individual investors will manage their own investments using one of the many tools or apps that can be easily downloaded to a smartphone. Schwab.com for example has a few apps that will allow you to monitor your holdings and even execute a trade. This type of unprecedented access to the markets has allowed the individual, or non-professional to easily buy and sell stocks with ease. This ease of access to trading stocks can be both good and bad depending on the direction of the market. Often the negative side effects of individual investing can lead to significant underperformance if trades are made at the wrong time.
Most people are affected by the 24 hour global, domestic and investment news cycles. News flow is real time using apps like Twitter, and the constant flow of news can often have negative ramifications for the average investor. As news flow comes in, it will affect emotions, and the behavior biases that we all have start to kick in and push people to action, or reaction. This push to action is often driven by emotional biases. Emotional actions, or reactions by investors can ultimately lead to underperformance.
To give another example of emotional and reactive responses, we can look at how people often use their Twitter account. The use of Tweets, or Twitter posts, is often the result of an impulsive response to a situation and often not a well thought out response. The use of a smart phone, the Internet, and the constant news cycle may similarly drive investors to impulsively respond to a news item without acting like a professional asset manager. A professional asset manager, like Robert Bender & Associates, will take many factors into consideration before making a buy/sell decision on a stock and will not impulsively react to a single news item or press release from a company. Our research is based on a wide array of data points, and rarely does a single data point drive our decision in a stock. Robert Bender & Associates will use a combination of fundamental, quantitative, and qualitative characteristics of a stock to form a top down and bottom up investment opinion. The bottom up analysis of a stock is merged with a top down analysis, or a broad market analysis, which helps us make a more informed and rational decision about an investment holding.
The joke on Wall Street goes that if the bus driver is giving you stock tips, or the construction worker is telling you an options strategy, there may be some irrational exuberance in the market. Let’s examine this. As the market cycle begins with a move from a low, a recession, or a bear market, there will be few people who want to jump into new positions in stocks. As the market cycle matures, more and more people will see that stocks are performing well and they’ll want to enter the market. As the market nears a top, literally everybody will become an expert at the stock market and they’ll be making recommendations about individual companies as well as trading strategies. While some recommendations are viable, often the analysis is lacking depth when compared to what a professional would apply to the situation.
The cost of making the wrong decision at the wrong time can be costly for your portfolio. Missing the 10 best days of the market over a 20 year period can have dramatic ramifications for a portfolio. As reported by BusinessInsider.com, the difference between staying fully invested and missing the best 10 trading days over a 20 year period can cut investment returns in half. The decision of when to put money to work, or pull money out of the market can have a dramatic effect on overall wealth. The timing of investment decisions is difficult for investment professionals, and often impossible for the average individual investor. We do not try to time the market, instead, the portfolio managers at Robert Bender & Associates invest using a data driven process that aims to limit emotional trading responses and aims to limit individual behavioral biases. Our goal is to implement a structured investment process to achieve above average returns for our clients while adhering to client portfolio objectives and constraints.
A professional investor is typically able to see beyond the short term market movements, and at Robert Bender & Associates we implement a top down and bottom up analysis to make more informed decisions. Having a professional invest assets can also help to ensure that the individual investor doesn’t let their emotions take over and a professional often avoids costly impulsive trading mistakes. When an investor lets their emotions make the trading decisions, they risk making the wrong decision. We encourage you to contact Robert Bender & Associates to inquire about our professional money management services.
Concerns with ETF and Mutual Fund Investing
The world of investing is riddled with decisions that have no clear cut answers. Most investment decisions are made with less than perfect information, and most decisions include a lot of estimates. This uncertainty, or risk, is usually a primary factor that helps investors to calculate an expected return from an investment. But aside from the risk inherent in a security or asset class, an investor must also choose the investment vehicle, which typically also affects the total return.
Once an investor makes a decision to invest into a specific strategy, they must then decide on the vehicle or method to implement that investment decision. With an investment in equities, for example, an investor can choose to invest directly into a portfolio of stocks using a separate account, or choose a mutual fund, an ETF(exchange traded fund), or an option/derivative. All of these methods for investing into equities are implemented in different ways, they will yield different returns, have different risks, different tax consequences and are typically invested into by different specialists. In this article, I’d like to discuss the benefits of investing into stocks using a separate account over a mutual fund or ETF.
Here are some risks and concerns of investing using a Mutual Fund as the vehicle for investing into Equities. Equities, or stocks, when sold will typically yield either a capital gain or loss which will accompany the transaction. A risk or concern with an investment into a stock, will be related to the taxable effect of this investment over time.
Concerns when owning a mutual fund or ETF:
- Taxable or Non-Taxable Account - First, as an investor considering a mutual fund, you will want to take into consideration the tax status of your investment portfolio.
- Holding period of the investment - How long do you plan on holding this investment, and is there a scenario where the funds would need to be accessed earlier than expected? The holding period of the investment will be used in a calculation of expected short term or long term capital gains.
- Fund Fees - Mutual fund fees are often well in excess of ETF fees so they are disadvantaged in this way over ETFs. ETFs have a major disadvantage over mutual funds in that they are usually passively managed, meaning all of the poorly performing stocks are lumped in with the better performing stocks. Because mutual funds are commingled the management expense ratios (MERs) need to taken into consideration.
- Separate account fees - If you choose to invest using a separately managed account, there will be fees associated with the management of this account. These fees can be similar to a mutual fund, or in excess of the mutual fund depending on the manager. Below we will talk about some of the benefits of having a separately managed account instead of a mutual fund or ETF. This analysis will hopefully help you to decide which investment vehicle is best for your situation.
- Built in gains/losses - At the time that you buy into a mutual fund, you are buying into existing gains/losses inherent in the fund. What this means is that you will be sharing in the gains/losses that earlier investors have benefited from. And, in a taxable account, if you buy into a fund and simply hold that fund through year end, you may get a tax bill because the overall fund is making buys and/or sells. If you must own a mutual fund, you are better off doing this in a non-taxable account.
Now let’s discuss the benefits of having a separate account for investing into equities:
- Buy/Sell Decisions - Most importantly, an investor can tailor their risk tolerance and work with their account manager to stay within their objectives and constraints. Tailoring your risk tolerance will allow you to create guidelines and boundaries for the portfolio manager to follow.
- Tax Consequences - More control over the timing of the taxable consequences of the account. One of the large downsides of buying into a mutual fund, is that you are buying into any existing gains or losses that the portfolio may have. This means that as a mutual fund has capital inflows and outflows, taxable events are occurring that may affect your account. Taxable events that can be passed on to you as a investor. One way to avoid these taxable events of a mutual fund, is to own them in a non-taxable account like an IRA. Depending on your situation, not owning a mutual fund or ETF may be the best decision.
- Transaction Costs - You can control the transaction costs by limiting the buys/sells. When you own a separately managed account, the amount of turnover in assets can be controlled to limit the added expense of transaction costs. In a shared account like a mutual fund or ETF, the transaction costs can be substantially higher and this cost is passed onto the investors.
- Taxable Gains/Losses - The timing of taxable events can be controlled by the investment advisor. Commingled accounts like mutual funds and ETFs don’t take into consideration any individual, they are managing the assets for the benefit of the entire fund. And so, the timing of you buying into the fund or selling are not relevant to their investment decisions. When you have a separate account, the gains and losses can either be managed and matched against long term and short term transactions to minimize the taxable effect to the account holder. The investments can be held on to until they are considered long term, and thus limiting the tax liability of the account.
- Your investment strategy run by a professional - A common problem that individual investors encounter, is making the wrong decision at the wrong time. It’s often difficult for an individual investor to find the time necessary to analyze the markets and potential investment decisions, which can make hiring a professional a wise choice. Whether that is at a separate account, a mutual fund, or an ETF a professional can help you to navigate the ups and downs of the markets. Any of these options are often better choices than running your investments on your own. With that said, when you have a professional managing a separate account, you will have the opportunity to discuss objectives and co-create a custom strategy for your account. The investment manager will take your preferences and help you to mold this into an investment strategy that is agreed upon by all parties. Once this is done, you as the investor should feel more comfortable that your investment targets will be prioritized within the confines of your objectives and constraints.
Choosing a mutual fund, ETF, or separate account is usually not a quick, simple or easy choice for an investor. Investors often get overwhelmed with making strategy decisions regarding the investment vehicle that is best for their situation. At Robert Bender & Associates, we specialize in managing separate accounts for investors because we feel the long term benefits are greater than investing in an ETF or mutual fund. Before choosing to invest in a fund, be sure to take all factors into consideration by comparing management expenses, total returns and potential tax consequences.
Compound Investment Returns – A path to achieving your investment goals
The topic of compound interest is a powerful investment concept that is essential for any personal investment strategy. Compounding can help you to slowly and steadily achieve your investment and retirement goals. Compound interest, or more commonly called “compounding” is defined by Wikipedia:
In a simple example, compound interest, or compounding your investments can be accomplished by seeding an investment account and allowing that investment account to grow over an extended period of time without withdrawing any funds. Over time, your investment will most likely generate capital gains, interest or dividend payments from your initial investment of capital. Here’s the essential part of compounding your investments: You must reinvest those new returns back into your investment strategy and allow that new cash work for you. When you do this, you will see your total invested capital grow slightly, and now your investment base is slightly larger than it was before. The reinvestment of returns over time can help your investment account to grow at an incremental rate.
To enhance the compounding of your investments, you should consider setting up a recurring investment each month into your investment accounts. The key to compounding is to allow any and all money to remain within the investment account and to reinvest any cash received back into your investment strategy.
To further this example, if you set up an investment account with $100,000 and it grows annually at 5% over 25 years, the total will grow to $339,000. In addition, if you also contribute $200 per month using the same example, your investment will grow to $453,000.
If you increase your expected return on your investments from 5% to 8%, you can start to see substantial growth in your returns over the same 25 year period. By slightly changing the assumption of growth rate from 5% to 8% and keeping the $200 per month contribution and an initial investment of $100,000 you will see your investments grow to approximately $860,000.
So what are the key tenets of compounding your investments:
- Invest consistently - Develop an investment plan that you can adhere to over the investment horizon.
- Reinvest - As most investment accounts generate cash over time, it is essential to allow your money to remain invested and allow your earnings to reinvest back into the investment strategy.
- Tithe to yourself - Set aside as much as you comfortably can each month to bolster your investment and savings accounts.
- Limit Withdrawals - Your investment account has the best chance of performing well if you avoid taking funds out of it. Allow your money to grow and also allow any interest or dividends to remain invested inside of your investment account.
- What if you fall off the horse? - Like all things in life, it’s hard to remain consistent for multiple decades. For example, over a 25 year period real people may find challenges in contributing a consistent amount, and it’s hard to commit to never withdrawing funds from your investment accounts. What’s important here is the concept, and staying dedicated to the concept of investing for the long term, staying consistent and committed to your investments.
Individual investors should be aware of compounding as a key concept to implement and consider during the planning phase of an investment strategy. You can visit Investor.gov to use their compounding calculator.