Growth Investing

Growth investors look for stocks with above-average growth in sales and earnings, typically at a 15% or higher annual rate. These are typically stocks of younger companies in a rapid growth stage of development, although larger companies can also qualify as growth companies. Growth companies tend to have higher price/earnings ratios with little or no dividends, since earnings are typically used to finance future growth. As growth stocks gain favor, investors tend to bid their prices up to lofty levels. Thus, the price/earnings (P/E) ratios of growth companies can be two or three times higher than the overall market. Earnings projections largely drive the value of these companies, so earnings disappointments can dramatically impact their value.

When searching for appropriate growth stocks, you should be looking for a fast-growing company that you feel will be able to sustain that growth for an extended period of time. Characteristics of fast-growing companies include a strong franchise and management, dominant market share and industry position, high return on equity, consistently superior earnings growth, high stock price and price/earnings ratios, and some stock price volatility.

How likely is it for a company to sustain above-average growth for an extended period of time? One study looked at companies in the Standard & Poor’s 500 (S&P 500) for the period from 1991 to 2003, and identified how many were able to sustain a 10% growth rate for multiple successive years.* During that time, 145 companies had a 10% growth rate for one year, but that declined to 22 for five years, three for 10 years, and only one for the entire 13 years. For the same time period, 87 companies experienced a 25% growth rate for one year, but that declined to 12 for five years and by the ninth year, no companies had a 25% growth rate (Source: Evading Mean Reversion, 2005).

Value Investing

Value investors emphasize stocks with market values that are low based on earnings, dividends, or assets. Companies in this category typically include those in out-of-favor industries, turnaround or troubled companies, or mature and stable companies with modest growth expectations. Dividend yield may be higher than average since the stock price is low. Signals that a company may be turning around include insider buying, improving profit margins, increasing earnings estimates, or higher trading volumes. Value investors must typically exhibit patience since it can take a while for the market to realize a particular stock’s value.

When searching for value stocks, you should look for a company with depressed earnings and a stock price that you feel will recover soon. Characteristics of good value companies include low stock price valuations, low price/earnings and price/book ratios, higher dividend yields, and short-term problems.

Which Style Performs Better?

Growth stocks typically do well when the economy is growing and the stock market is rising, while value stocks typically do well when the stock market is peaking or falling. Many investors are naturally drawn to a growth investing style since growth stocks usually have exciting news, capturing much press attention. Value companies often receive unfavorable press, requiring more resolve on the investor’s part to continue holding them.

So which style will excel in the future? Just as you can’t predict where the market is headed, it is difficult to determine when each style will dominate. Thus, it may make more sense to include both styles in your portfolio. That way, no matter what style dominates, it will be represented in your portfolio. One study reviewed the performance of a value portfolio, a growth portfolio, and a portfolio with 50% value stocks and 50% growth stocks during the period from 1981 to 2003. Over three-year rolling periods during that time, the combined portfolio outperformed the S&P 500 57% of the time, compared to 53% of the time with growth stocks and 52% of the time with value stocks. The combined portfolio outperformed the S&P 500 62% of the time over five-year rolling periods and 75% of the time over 10-year periods (Source: Strategy and Tactics in Style Investing, Autumn 2004).

* The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.