While the world equity market was reeling under the subprime chaos, there was a small news item, which probably slipped attention of many. Investment guru Warren Buffett was quoted as saying “worsening credit and housing markets may provide some real investment opportunities.” Generally speaking, when there's a certain amount of chaos in certain sections, it is unpredictable where the fallout will be, but the fallout offers some real opportunity. It may surprise many but investing in the end seems all about conviction and lateral thinking.
Mr Buffett with his successful investment track record has created a cult of investment followers. In fact, some days back S&P's came with finding that Infosys , Wipro and Satyam would have fulfiled his investment criteria. His investing picking style is unique, in that he uses a blend of value and growth investment philosophies. He once said “ I am half Benjamin Graham and half Philip Fischer” . While the former is a thorough value based stock picker, the latter has dabbled with growth strategies . Worldwide equity investors seem to be divided into these two distinct styles of stock picking - Value and Growth. Both are quite popular stockpicking strategies so let's first understand who's who.
Value Investing - 'Offer till stocks last'
Don't we rush to pick things on sale thinking that its real worth is more than the offer price. This is what value investing simplistically put means. Investors that follow this style specifically target companies with strong fundamentals in terms of earnings, dividends, cash flow, etc but are trading below their actual worth (technically it's called intrinsic value). Investors believe that a value stock is created due to over reaction to particular news affecting the industry only in the short term. Benjamin Graham pioneered this method of investment. His investing style was invented from his bad experience in the 1929 stock market crash in US and therefore one could see that his investment principles are more defensive in nature.
He insists on 'margin of safety' , which is nothing but the discount to the intrinsic value that the stock price is currently quoting at. Wider the discount , more is the margin of safety. The parameters he uses to pick stocks are low price-to-earnings ratio, price-to-book ratio or price-to-sales ratio. Some of these stocks may no longer be the flavour of current investors but again, the fundamentals make a strong case that the stock will bounce back and 'show its true colour' . Value stocks are not sector-specific as an attractive bargain can almost be found anywhere, but the probability of locating them today is more in energy, financial service or healthcare sectors.
A word of caution here - a value stock available at a bargain does not mean that any stock that has taken a plunge will qualify as a candidate in this category. A company that has hit 12-month low may not necessarily be a value stock. A stock's sudden fall may be the market's reaction to some fundamental problem of the company and thus refuting the basic criteria for categorising a stock as a value stock.
Before qualifying a stock as value pick one must ensure that the debt of company does not exceed its equity and it has shown a healthy earnings growth over the past few years. One might also get into 'value trap' in which the low stock price never recovers in one's holding period and hence may not get expected returns.
Growth Investing - 'Mining Diamonds'
Unlike a value investor, a growth investor is concerned with the future potential of a company, and less interested in its current trading price - quite like mining diamonds knowing that it will give good returns once it is 'cut and polished' . Growth investing is based on figuring out companies that have the competitive edge to become the next Reliance, Infosys, ITC or Hero Honda. A typical growth company has expanding business model and reinvests its profit for extending operations.
They are represented by high price-to-earnings ratio and price-to-book ratio. As a thumb rule, they generally show considerably high return on net worth/ equity (RONW or ROE). This indicates that its shareholders are current enjoying its growth story in the form of higher ROE. A company that has shown robust growth in profits and is expected to do even better in future is a good candidate for classification as growth stock. Investors are ready to pay a premium for such stocks factoring in the future growth potential which leads to its high P/E ratio. They believe that increasing top line and bottom lines will automatically translate into higher stock price and hence will take care of the return. At current juncture, companies in the infrastructure and IT sector would be good examples of growth stocks.
The risk involved here is actual growth falling short of expectations, for which you have already paid a premium. This may be due to poor revenues and earnings and may lead to a slump in the stock price.
To pick or to mix
Now this is an on going debate. It is difficult to predict which strategy will outperform the other. If there are cases showing that value investors have outperformed growth over a period of time, the support on the growth investor side may be no less.
In fact, both these stock-picking strategies compliment each other well. So, instead of sticking to one strategy , an investor may strive for decent returns with low risk by combining growth and value investing - quite like diversifying one's portfolio across sectors to minimise risk and add up returns.
Common parameters used by fund managers:
P/E below 16 or P/B value below 1
Debt to equity ratio below 1
Dividend yield of 5% or more
Companies showing consistent growth in sales and profits
High return on equity (16% plus)
Firms with higher earnings margin