3 stock investing strategies: Growth vs. Value vs. Income
So, you’ve decided to invest. The next thing to do is work out how to go about it. Should you invest in growth stocks? Value stocks? Or income stocks?
This guide explains what they are, how they’re different, and how you can choose a strategy that’s right for you.
Strategy #1: Growth Investing
Growth investing is about picking companies with strong earnings growth prospects. These would typically be newer companies, in younger industries (e.g. technology) and/or in emerging markets. Growth investors are looking for capital appreciation, which they hope will occur when the companies they invest in grow revenue and earnings rapidly.
Investors should be prepared to be invested over the medium term at least, to have better chances of seeing the companies’ business expansion programmes turn in higher profits.
To spot your growth stock opportunities, understand
- The growth prospects of the companies you follow;
- The competitive challenges they face in achieving growth;
- Whether they can achieve their expansion plans without running into cashflow problems
To determine these, look at these factors:
|Factors||What to look at|
||What are analysts saying about the company’s EPS prospects in coming years?|
||Are delivering good returns to shareholders even as they are growing their businesses?|
||Does the company have positive cash flows? If not, their expansion plans might endanger their financial stability.|
||Are they able to meet their financial commitments as they come due?|
The risk of high growth companies is that they may over-spend on investment, and not have enough funds to sustain them while they’re waiting for their expansion programmes to generate cash flow and profits.
Strategy #2: Value Investing
Value investing is about picking companies that are trading significantly below what’s normally regarded as “fair value”. Like growth investing, value investing is also about capital gains. But the way these companies go about generating capital gains is different. For value investors, it is about spotting companies which are trading undeservedly at relatively low price to earnings ratios, below book value, or even below cash value.
The key word here is “undeservedly”. Stocks are sometimes cheap because they have run into financial difficulties since the last financial year-end. In those cases, the historical price to book (P/B) and price to earnings (P/E) ratios may not be relevant any more.
Markets are generally quite efficient at pricing stocks. So, you don’t usually get undervalued stocks for no reason. There is usually a reason. To spot a genuine value stock opportunity, you need to understand:
- Whether these stocks are undervalued relative to similar stocks;
- Whether their undervaluation is due to
- Some transient/passing problem;
- Temporary sentiment; or
- Something more fundamental and lasting.
Value stocks may require patience as it sometimes take many years for value to be restored. Often a stock becomes undervalued because of transient difficulties which may pass over time. The challenge facing the value investor is to determine whether the underlying business is still sound and whether the company can overcome the prevailing difficulties. In human terms, it is determining whether the injury is fatal, or a flesh wound that will heal.
Some things to look at in determining the above are:
|Factors||What to look out for|
|Underlying business||Whether the underlying business has been damaged beyond repair|
|Financial resources||Whether the company has the financial resources to ride out a rough patch - and you can gauge that through indicators such as debt to equity ratio, its current ratio, and whether it has been generating positive cash flow.|
In determining “value”, it is useful to look at its price to earnings and price to book ratio relative to its industry peers, and also relative to its own price history.
Strategy #3: Income Investing
Income investors is about picking companies that are generating stable earnings, pay a good amount of their earnings as dividends to their shareholders (good pay-out ratios), and have strong underlying assets or businesses. This sort of companies are typically mature companies.
Contrast this to growth stocks, which are typically younger businesses that are rapidly expanding. Hence, they are using up a lot more of their earnings in expansion and hence have lower pay-out ratios. Or they may be investing so much, and those investments are still in the early stages of revenue and earnings generation, they have less earnings.
Income investment opportunities are often found in utilities (e.g. telecommunications companies, toll road owners, energy generators) and real estate investment trusts or REITs.
For income investing, you want to look for:
- Stability of earnings;
- A stable and high pay-out ratio;
- The dividend yield (or distribution yield for REITs) over a risk-free asset such as the 10-year Singapore Government Security yield.
Which style/strategy should I use?
This often comes down to personal risk appetite and preferences. In general, value investing can offer bigger gains than income or growth investing, because the company has fallen significantly below the valuations of comparable companies. Another situation where value investing opportunities open up is during times of financial crisis. When the crisis passes, valuation is quickly normalised, often offering unusually large gains.
But both these situations involve considerable risk. So, this is for investors who have a stomach for risk and patience for the situations which have caused undervaluation to pass.
Growth investment has its own risks as well. The biggest risk is of overexpansion resulting in financial difficulties and sometimes even insolvency where a company’s investment/expansion plans fail. But generally, where a company has a good business and a sensible expansion plan, growth companies tend not to be as risky as undervalued stocks.
Generally speaking, the lowest risk strategy/style is income investing. They are usually in mature companies with proven earnings-generating businesses, which pay out reasonably stable dividends. But they generally have much less potential for capital gains than growth or value stocks.
A diversified approach is to have a mix of growth, value and income stocks as you grow your stock portfolio. In other words, don’t put all your eggs in one investment style. And as you diversify, it may be useful to look overseas for investment opportunities, in markets such as the US, Europe, Japan, and Hong Kong.