Individual equities are typically classified as either value or growth. With mutual funds, these two terms are referred to as style; they can exist independently or blended, a term used when a fund holds both value and growth stocks. We’ll outline some of the main differences between these two classifications or styles.
Blue-chip equity is a term associated with the best quality value stocks. These stocks are most often in the mature end of the corporate life cycle. Value investors seek to purchase shares in a company at a price, which is low relative to the intrinsic value, or the perceived true value of the company. Intrinsic value can be compared to the actual market price of the shares publicly traded. These valuations can also be compared to similar companies within the same sector. It may be easy to value cash on the balance sheet and other identifiable assets where the market value is easy to determine. The challenge with value investing is taking into consideration off balance sheet holdings or intangible assets such as trademarks, rights, patents, real estate holdings.
After acquiring a stock at a bargain price the goal is to sell it when the valuation level rises. Buy low and sell high involves a great deal of patience, as it could take several quarters or years for price appreciation. From an investment objective standpoint, many value stocks are best classified as long term capital appreciation. These stocks should help you grow wealth slowly.
Most value companies pay a steady quarterly dividend. These dividends in value stocks provide cash flow for income investors. These dividends can also act as a source of growth for value investors even if the share price remains flat. If income is not required, then income can remain in the account. Many stocks have a Dividend Reinvestment Plan (DRIP) that can enhance growth over time for investors who have value stocks.
As an example, use XYZ Company, with shares trading at $50. If the current dividend is $1.70 per share then the stock is yielding 3.4 per cent ($1.70/$50). If the stock price declines to $40, then the yield will increase to 4.25 per cent ($1.70/$40). If the price of the stock increases to $60, then the yield decreases to 2.8 per cent ($1.70/$60). As the yield increases, the stock becomes more attractive from an “income standpoint” which acts partially as a floor for value stocks.
In hindsight it is easy to identify stocks that have exhibited faster than average growth in earnings over the past few years. Apple Inc. has been a great example of how even large companies can exhibit earnings growth that is superior to the overall market. Growth investors seek to invest in stocks that have future potential of earnings growth and share price appreciation regardless of the current price. Growth investors also have the objective of selling higher. Momentum trading is more closely associated with growth investing. They are in the early stage of a company’s life cycle. Growth stocks may or may not be profitable. These companies may have cyclical cash flows that can put significant strains on the business in certain economic conditions. Growth stocks may be considered riskier than value investments for the above reasons. During market downturns, growth stocks typically decline more than value stocks. When market conditions are favourable it is possible to have greater returns in a shorter period of time. Short term capital appreciation is often associated with speculation and growth stocks.
To help overcome some of the above risks, most growth stocks do not pay a dividend. Some do not pay a dividend because they are not yet profitable (no retained earnings). Profitable growth companies often retain profits to put back into the company to fund further expansion. Growth companies may be continually reinventing themselves by reinvesting in processes and technologies that keeps them competitive. Maintaining a cash reserve necessary to survive during difficult times is also essential for a well managed growth company.
Sector and Style
Sector diversification and style often go together. When people are looking at sector diversification they are already diversifying between value and growth. Large financial and consumer staple companies are prime examples of value stocks. Companies within the materials, health care, and technology sectors are generally considered growth stocks.
One way to look at value and growth may be by looking at the size of a company. Small companies in the energy, materials, health care, and technology sectors are considered growth in the initial stages. It could be argued that all companies start out as growth. It is also possible that successful growth companies become value stocks over time.
If you hold mutual funds or other managed investments in your portfolio, you’ll want to pay attention to the management styles of your holdings. Some managers may be active traders with a growth bias, while others hunt for bargain investments and keep them for several years. Both of these can be excellent styles; however, styles tend to go in and out of favour and investing in one management style can be riskier.
Fundamentals Are Key
Looking at the ratios of a value company is different than for a growth company. First of all, a value company is easier to initially screen over a growth company. As an example, we would expect the Price to Earnings (P/E) ratio to be lower for a value company than a growth company. When screening for good value companies we would typically begin by looking at the Price to Earnings Ratio, Dividend Yield, and Price to Book Value. When screening for good growth companies we would typically look at Sales Growth, Earnings Per Share Growth/Momentum, Debt to Equity Ratio, and Consensus Analyst Target Ratings. Regardless of the style it is important to look at the fundamentals of each company. Not all companies fall clearly into one of the above two investment styles.