Deciding how to allocate the money in your portfolio is one of the most imperative tasks for an investor, considering that as much as 90% of a portfolio’s return is determined by the way the monies are divvied among the major asset classes of stocks, bonds, and cash. 1, 2
Once you establish how much of your portfolio to place in stocks, what is the best approach for picking stocks under these volatile market conditions?
While there is no "one suits all" approach, following a defined strategy can help simplify investment decisions, providing guidelines and a basis for selecting one stock over another.
Two predominant investment strategies are growth investing and value investing, and there is much debate about which should be favored over the other. The fact is, they both have their merits, and many strategists suggest using them in combination to build a robust and diversified portfolio, with the goal of maximizing profits, balancing risk and combating market volatility.3
About Growth Investing
Thomas Rowe Price, founder of T. Rowe Price and Associates, pioneered the method of growth investing. His strategy focused on well-managed companies in developing industries whose earnings and dividends were expected to grow faster than inflation and the overall economy.4
Growth investors are more concerned with a stock’s future growth prospects than they are with its current stock price. Companies whose earnings grow the fastest see their stocks appreciate the most in the short-term – since the market tends to reward growth.
Companies potentially achieve accelerated growth in many ways: through superior technology, higher quality products and more innovative marketing. Or, a company might gain advantage by being first-to-market in a new business niche, or by enjoying other efficiencies its competition does not. Often, a successful growth company benefits from more than one of these advantages.
How do you spot a growth stock? The general characteristics of growth stocks are:
- Low dividend yields (since young companies tend to reinvest earnings),
- high price-to-earnings ratio, and
- high market price-to-book ratio.
- low market price-to-book ratio,
- low price-to-earnings ratio and,
- high dividend yields.
About Value Investing
The principles of value investing were conceived by Columbia University professors Benjamin Graham and David Dodd. Modern day value strategists, like Warren Buffet, search for bargains – high quality companies with strong fundamentals and earnings potential that the market may have underestimated. They seek stocks that have fallen out of favor and are currently trading below historic averages or below industry peers. For example, if a company is restructuring or experiencing earnings problems, value investors may view a downturn in its stock as a temporary situation that will correct itself when current conditions improve.
This is where the concept of value comes in — value investors consider whether a stock is a good buy, based not only on its future prospects but also on the price being paid for it. To value investors, the key to recognizing an undervalued stock is to determine its intrinsic value – which is its fair value based on underlying observations of the business. To start, they examine company fundamentals, looking at both qualitative measures (business model, target market, regulation) and quantitative measures (financial statements and ratios) to gauge if the company may be worth more than its current valuation.
To analyze intrinsic value, value investors rely on a core principle known as the "margin of safety," which is the difference between what is determined to be a stock’s intrinsic value and the actual stock price as set by the market. In concept, a high margin of safety would reduce risk of the investor overpaying for the company’s stock and allow for a greater profit margin. In practice, the stock price upon sale may be higher or lower than the actual purchase price.
To single out potential value stocks for a closer look, watch for these general characteristics:
Growth and Value Strategies in Action
Looking back over 30 years, growth stocks and value stocks have performed cyclically, taking turns outperforming one another. Cumulatively, the difference between the two strategies amounts to less than one half of a percent over that time period.5 The styles generated similar returns when implemented as a long-term investment strategy. Used in combination, growth and value investing may provide the benefit of diversification — as the value portion of a portfolio zigs, the growth portion can zag and vice versa. Over time, investors may achieve the same returns either strategy might produce independently, but with potentially less volatility and anxiety along the way.
Sources: 1. Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, "Determinants of Portfolio Performance II: An Update," The Financial Analysts Journal, 47, 3 (1991). 2. Roger G. Ibbotson and Paul D. Kaplan, "Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?" Financial Analysts Journal, Jan/Feb 2000. 3. Mark Biller, "Why You Want Both Growth and Value Investments," Sound Mind Investing, August 2009. 4. John Train, The Money Masters, Harper Business, 1994. 5. Cambridge Associates and Morningstar Principia, "The Cyclical Nature of Growth vs. Value Philosophies."
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