7 MinsJan 25, 2021
Two fundamental approaches exist to investing in equities viz., ‘Value Investing’ and ‘Growth Investing’. Value investing usually looks for undervalued stocks or stocks trading at less than their intrinsic value, while growth investing looks for companies that have a high potential for growth in their revenues, earnings and/or cash-flows.
Both these approaches have their own set of principles. Ideally, your portfolio should have a mix of stocks or funds that follow these approaches, as they serve different purposes
Let us understand these approaches in detail.
The value approach, as mentioned earlier, usually looks to pick undervalued stocks, i.e. where the current market price of the stock is lower than its intrinsic value. The basis for value investing is that fundamentally strong companies usually overcome hurdles over time and their stock prices will eventually begin to reflect in their actual worth. Besides, when the economy recovers, such companies may do well and give higher dividend payout.
How to identify Value Investing stocks?
To identify value stocks certain key parameters need to be looked at carefully. You could select your own set of parameters or quant model to pick stocks on value investing principles. You could also research and follow recommendations by experts, such as, Benjamin Graham, for instance, who is considered the Father of Value investing.
Some broad parameters you could look at while selecting value stocks include:
Quality rating-Find above average or better rate companies. One strategy could be to look at companies with a B+ ration or more
Current Ratio-It is calculated as Current Asset divided by Current Liabilities. It helps to assess whether the company under consideration has enough resources or ability to pay its short-term abilities
Earnings Per Share Growth-The Earnings Per Share (EPS) is calculated as Net Profit after Tax and Preference Dividend divided by the Number of Outstanding Equity Shares.
Price-to-Earnings Ratio-This ratio calculated as Current Market Price of the Share divided by the Earnings Per Share (expressed in times) may help you evaluate whether the company is overvalued or undervalued compared to its peers in the industry. Ideally, look for companies where the P/E is lesser than the peers.
Price-to-Book Value Ratio-It is calculated as Current Market Price of the Share divided by the Book Value Per Share (expressed in times), this ratio indicates how expensive, reasonable or cheap the stock is trading when compared to its Book Value amongst the peers in the industry.
[Also Read: Investor Bias – know what it is and how to avoid it]
Dividend History-As a value investor it is important to select companies with a good dividend track record. Because investing in an undervalued company may mean waiting for a considerable period to reap its full return potential.
Do keep in mind that in value investing, there are chances of being stuck in a value trap (very high losses) or a deep value stock (much longer time period for turnaround). This may make it difficult for retail investors to select Value stocks.
This approach involves investing in companies that have the potential to grow faster on the backdrop of certain good news; have differentiated product offering as compared to its peers. These companies usually outpace their rivals by innovating new products; which are well accepted in the market, have agility in their business models, and offer more growth opportunities than some of the not-so established players.
In Growth Investing, investors are usually willing to pay a higher price in anticipation of higher growth or return on investment. Therefore, the valuation ratios (Price to Earnings, Price to Book value) of growth companies may be placed on the higher side.
During a bull run or during times of economic growth, growth investing does well. Growth opportunities can be found in companies across market cap, i.e. large-cap, mid-cap and small-cap, depending on their future business plans that hold the potential to clock higher Return on Equity (ROE).
Do note that when the focus is on growth, the company may not necessarily declare attractive dividend payouts even though its profitability year-on-year may be remarkable. The company may reinvest earnings back into their business for future growth– organic or inorganic.
Qualitative factors are very important today and one must further research and evaluate basis qualitative factors irrespective of the approach you follow – value or growth. Some of these factors include:
• You should not evaluate a company’s stock based on only quantitative aspects, but you should also research and know as much about the company and the industry in which it operates and carry out a thorough qualitative assessment.
• The company must have a significant ‘economic moat’ – which refers to the competitive advantage it enjoys. Larger the advantage, wider is the moat. The moat of the company can be identified by its brand value, the patent it holds, the size of its operations, the market share, the stickiness of its consumer base (loyalty), corporate governance and culture (which are soft moats), among other facets.
• Moats usually protect the business from the competition. And if the company can use its competitive advantage to widen the moat over time, then it is the perfect business to be in as it may earn you higher dividend-adjusted returns over the long run.
• Besides, it is necessary to evaluate the management, understand how the capital is deployed, how shareholders are treated, the corporate governance standards, and whether the management has been able to steer the growth of the company.
The mutual fund route
You can enjoy the long-term benefits of both Value investing as well as Growth investing by investing in mutual fundsthat follow these specific approaches.
A Value Fund as categorised by SEBI follows a defined style of investing, namely 'value'; and it is expected to maintain a minimum 65% investment in equity & equity related instruments following the value theme.
The fund manager of a Value Fund usually follows a bottom-up approach to stock-picking. The portfolio of a Value Fund may be market-cap and sector agnostic. That being said, broadly, a Value Fund is a high risk-high return investment proposition and is placed relatively higher on the risk-return spectrum. One should consider the risk profile and suitability before investing in the scheme and have an investment time horizon of at least 5 years.
Do not lay emphasis only on the past performance to pick a Value Fund. This is because, past performance – good or bad – is not necessarily indicative of future returns.
Choose a Value Fund from a mutual fund house that follows a robust investment process & systems with effective risk management strategies in place.
Similarly, if you find it difficult to pick growth stocks, you may consider diversified mutual funds with the mandate to invest in large & mid-cap/small-caps or multi-cap funds which adopts growth style of investing in their stock selection process. To pick a mutual fund best suited to your needs, click here.
Which is better: Value Investing or Growth Investing?
There is no specific right or wrong when choosing an investment strategy for stock selection. Both approaches have their own merits and demerits.
An investor should diversify their portfolio by investing in both styles of investing. It is also important to consider the current market situation, your risk profile, financial goals, and the time horizon for your goals.
Remember, a stock cannot remain a Growth or Value pick forever. To create your stock portfolio and invest for your future, open your Axis Direct 3-in-1 Account today.
Disclaimer: This article has been authored by PersonalFN, a Mumbai based Financial Planning and Mutual Fund research firm. Axis Bank doesn't influence any views of the author in any way. Axis Bank & PersonalFN shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision