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Thursday, October 1, 2009

About Growth Stocks and Value Stocks

Should the title of this post be changed to Growth stocks vs. Value stocks? So many dichotomies have become part of our everyday lives - like Good vs. Evil, Black vs. White, East vs. West, Fundamental analysis vs. Technical analysis - that we have come to believe them as truths.

The reality is different. By creating compartments and divisions through our imagination or dogma, we get into behavioural patterns that are detrimental to our emotional and financial well-being. Once we decide to cut the Gordian knot of needless differences, life and investments become so much simpler.

Enough philosophy for a short week of trading. Let us get down to the nitty-gritty.

What is a Growth stock?

These are stocks belonging to companies that have shown a consistent above-average growth in sales or earnings in the past, and are expected to maintain the rate of growth in future. One measure of growth is RoE (Return on Equity) above 15%.

To fuel such growth, cash is a major requirement. So companies often forego dividend payments to plow the earnings back into the business. When the earnings are inadequate to fund the growth, companies resort to share issues and debt.

Typically, these are high P/E stocks with volatile price movements that make them risky to own. Investors expect to make large capital gains and often get trapped by the 'greater fool theory'.

What is a Value stock?

These are stocks belonging to companies that are considered to be trading at a level lower than their intrinsic values, as determined by fundamental analysis of sales, earnings, dividend payments.

These stocks have low P/E or P/BV ratios and high dividend yields. Hence they have lower risk and a bigger 'Margin of Safety'. Value stocks tend to out-perform growth stocks during bear markets and under-perform in the later stages of bull markets.

Like in life, which has more shades of gray than black or white, there is no distinct dividing line between a Growth stock and a Value stock.

No company can have a high growth rate forever. Sooner or later, as its size increases, growth rate will begin to slow down. If it survives, it will become a stalwart and pay regular dividends and grow steadily.

The key phrase is: 'if it survives'. Taking on too much debt, or issuing too many shares in the singular pursuit of growth can weaken the balance sheet so badly that the company can collapse under the weight of its interest payments. Stocks from the retail and realty sectors come to mind.

Should investors choose Growth stocks or Value Stocks for their portfolios? It need not be an either/or situation. Why not choose Growth stocks and Value stocks?

How about using the 80-20 rule? Keep 80% of your portfolio in Value stocks, and 20% in Growth stocks. Remember that the best time to look for Value stocks is when the stock market is down, not when it is up 70% from its recent low. That doesn't mean that Value stocks are not available in bull markets. They are just very difficult to find.

(Do you have an opinion about any good growth or value stocks in the current market? Please share it here for the benefit of other readers.)

9 comments:

Madhu said...

Very good explanation in simple terms.
Just to add to your write up.
Sometimes selection of quantity of growth stocks in a portfolio has to be based on the type of markets it is invested.
Like in markets like India and China, growth stocks should be given higher share in comaparison to markets like the US and EU.
Developing countries are characterised by higher growth while developed countries strive for more value addition rather than growth. So the investment theme ahould be altered accordingly.
However I support the arguement that it is "and" and not "or" in this case.
Your views please.

Subhankar said...

Thanks, Madhu.

I prefer to look for value in large-cap stocks which have been beaten down for various reasons.

Growth stocks give fabulous returns in the later stages of a bull market. But you need to latch on early and bail out in time, otherwise they may fall sharply and stay down for a long time.

Preservation of capital and gradual wealth building should be the primary motives - better achieved through value stocks.

Growth stocks can generate some extra returns. Have seen too many 'rising stars' disappear into the sunset!

tax_trp said...

dear sir
your liking and bias for large caps which are leaders in an industry or a sector is justified.
Investments in large caps and leaders has its own advantages and drawbacks.
Advantage is that u preserve your capital with not more 12-18% returns.
[i have read it somewhere that CAGR of dow jones if remained invested for 20 years is not more than 12%-18%].
Drawback is that capital does not grow fast.
Rakesh jhunjhunwala started his investments with 5000 which is believed to be valued whopping 5000 crores,in just two decades.
I have seen his porfolio through google search, none of the stocks are large caps, he invests only in growth stocks.
If i get a meagre 12-18% in large caps in compare to 8-10% in bank fix deposits, i dont think its worth to be in share market burning mid-night oil just for extra 4%-8%, doing all sort of research, tracking management,cashflows share price movements etc.
Also we know stress, anxiety, mood swings becomes part and parcel of equity investor's life.
All these just for extra 4%-8% returns?
I would prefer to go for killing in growth stocks rather than being killed in largecaps.
your comments please.
mansoor panjwani

SG Money Mind said...

Until a year back, I had the thinking, growth means better returns. But I learnt it rather lately that, growth on its own doesn't deliver returns to the investor. Instead, the RoE (or RoIC) takes the number one priority.

A business which has wonderful RoE, accompanied by a wide moat (or atleast a narrow moat), bought at a fair value price would produce wonderful return (over a long period) to the investor even if the Y-o-Y growth is meager. A classic example is See's as documented by Warren Buffet.

For your blog reader's benefit, it is captured in my blog at the following link.

http://singaporemoneymind.blogspot.com/2008/09/what-to-look-for-in-business.html

Warren Buffett's following quotes answer the growth vs value logic in precise terms.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.

Growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years... those who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance. Growth is simply a component-usually a plus, sometimes a minus-in the value equation.

Subhankar said...

@mansoor: Guess you missed the point of the post. It was about Value stocks AND Growth stocks.

I'm a pacifist, and don't believe in either 'going for killings' or 'getting killed' in the process!

Here is another quote from WB:-

"In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor."

@SGMM: Thanks for the link to the See's Candies story.

Losing money can be a great learning experience. Unfortunately, many small investors go on repeating their mistakes, and then blame their luck, or the FIIs, or the 'operators' for their losses.

sudipto said...

Subhankar da

I am from kharagpur. By luck i came across your blog. It really amazing.Keep the good work going Subhankarda. Congrats.

Subhankar da i have pantaloon retail, indian bank, Gayatri projects, onglobal mobile, godrej industries, FCH, Idea, mahindra satyam sundaram finance in my account. If possible please suggest me. Thanks in advance. Please pardon me if I am asking much.

sudipto

Subhankar said...

Appreciate your comments, Sudipto.

I've posted about Gayatri Projects and OnMobile Global - check the links on the right panel of my blog.

I've covered Pantaloon Retail in a post about the retail sector on Sep 15 '09. You'll find it from the blog archive.

Don't track any of the other stocks.

sudipto said...

Dear Subhankar da
Thanks for the response. Sir i have no idea about charts. Sir i have read about your comments but cant see whether pantaloon retail is a sell or hold candidate. I will be a lots of help is you can suggest me.
thanks in advance.

Subhankar said...

You can hold with a stop-loss at 285.