As you become a better and more experienced investor, you may hear a lot about value investing versus growth investing. The true professionals know, in the words of Warren Buffett, that value investing and growth investing are joined at the hip because all investing in value investing. The growth rate of a company is a fundamental part of the process when valuing a stock or business and in some cases, adds to the value, in other cases, detracts from it.
What People Mean When They Discuss Value Investing vs. Growth Investing
Commonly, when people talk about a value investing strategy, they picture a portfolio manager or private investor buying shares of companies that have one of the traits you learned in Common Characteristics of Value Investing Stocks such as a low price-to-earnings ratio, low price-to-book ratio, a high earnings yield, high dividend yield, etc. Although these are common similarities of companies that could rightfully be called value investing stocks, the entire concept of value investing is buying the most future earnings at the lowest price. In other words, an investor that managed a portfolio with a true value investing strategy would be much happier buying shares of Johnson & Johnson, one of the strongest and most profitable companies in the world, at 12x earnings than he would be buying a small, mediocre tool company in the middle of nowhere trading at 7x earnings.
In contrast, when people talk about growth investing, they often mean stocks that have high price-to-earnings ratios, explosive growth, and firms operating in exciting fields that are on the cutting edge of society’s innovation. Growth investing as it is commonly understood on Wall Street is the search for the next Microsoft or Cisco in its early days. Unfortunately, the problem with growth investing is that it is often nothing more than momentum investing as practiced, meaning portfolio managers attempt to load up on the best known stocks with attractive, high-profile stories, and buy them as the price goes through the roof.
A hybrid approach is something known as growth-at-a-reasonable-valuation investing. Investors that practice this discipline seek better quality companies with above average growth rates but seek to buy them on a value investing basis.
Value Investing Generates Far Higher Returns Statistically
According to research by Ibbotson & Associates, value investing, defined as buying shares of companies with value investing characteristics, has far outperformed growth investing stocks over the past century. Often, this is because the stock price of companies over the long-term follow the same trend as their earnings per share. Companies that are overvalued will eventually revert to the mean, as will companies that are undervalued. This helps explains how railroad stocks, with dividends reinvested, have beat the S&P 500 over the past century despite having horrible returns on equity and years of unprofitable operations at a time followed by boom periods and even some high profile bankruptcies.
The bottom line for investors is that the price you pay for any asset, whether it’s a stock, bond, real estate, commodity, annuity, or artwork, ultimately will determine the return you earn on that asset. This is a truth as old as sales itself (that’s why merchandisers used to say, “Well bought is well sold”). Make sure you don’t overpay for even the fastest growing company, and you should make money. It really is that simple.