Fresh off the heels of this basic but useful post about the difference between earnings and cash flow comes another trading challenge student named Julie talking about the differences between value and growth stocks!
This is what makes markets, since for every buyer there has to be a seller and vice versa. There are two groups of investors that tend to focus on different types of stocks. We’re talking about growth and value stocks. This blog post is going to dive deeper into what characterizes a growth stock and a value stock as well as the people that invest in them.
A growth stock is a company whose earnings are expected to grow at an above-average rate relative to the market. Since they tend to reinvest their earnings into company projects, they do not typically pay dividends. The tech sector is known for being made up of mostly growth stocks. Growth stocks are expected to be impervious to economic fluctuations.
Growth investors believe in buying stocks with above-average earnings growth and disregard the current price of the stock. The guiding principle of growth investing is to look for companies that keep reinvesting into themselves to produce new products and technology, in other words, they focus a lot of their capital on research and development.
A value stock has a tendency to trade at a lower price relative to its fundamentals. The fundamentals could be things like earnings or sales. This causes the stock to be considered undervalued by a value investor. The common characteristics of these stocks are: a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio. A value investor has the belief that the market isn’t always perfectly efficient and that finding companies trading for less than they are worth is a possibility.
Value investors look exclusively for stocks that are trading at a discount to their usual valuation or what people calculate they should be worth based on things like future earnings projections. It’s important to know the difference between growth and value, because they react differently in economic situations. A value stock’s earnings typically fluctuate with the economy and tend to do well when the economy is accelerating out of a recession.
Another big difference is how the investors view the market. Growth investors are very forward looking. They propose that companies with above average growth rates will generate returns that are also above average. The problem with this strategy arises with the realization of that growth. In order for the price of the stock to rise, the company needs to achieve those growth expectations.
On the other hand, value investors look at history. They take a lot of time to examine financial statements to estimate the value of the stock to compare it to the current trading price. If the calculated value is a significant amount lower than the current trading price, the investor will buy the stock. The problem arises in getting people to agree on what the calculated value should be.
There are studies that show your returns benefit over time when you buy stocks that are cheap relative to others, aka a value stock. To explain this, think of price to earnings ratios. Suppose stock XYZ typically trades with a P/E ratio of 15 to 25. If you buy XYZ when it is trading at a P/E of 16, and then it goes to 22, you can sell it when the P/E ratio starts to fall back towards the lower end of that increment. This isn’t a risk free investment. If it were, everyone would follow this strategy. Risk becomes involved since you face the possibility that XYZ’s P/E has fallen because the company no longer justified at that level due to various reasons such as business outlook or macroeconomic factors.
Taking both of these strategies into account, you might ask why people don’t simply invest in a stock that has a low P/E and a rapid rate of earnings growth. Well, this is because these situations are rare. Any hint of growth attracts investors and increases the stock price. This doesn’t mean that these situations never happen, you just have to do a lot of research and be prepared to act quickly. People make and lose money with each of these strategies, so it is more or less about finding out which is right for you and then adjusting accordingly.