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.