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Growth vs. Value Investing

Growth and value are often considered two different investment strategies. The reality is that they are just dual components of one proven strategy. The aim of finding a growth or value stock is to find a stock that is undervalued by the market. Either the market underestimates the stock's growth prospects, or the market currently fails to appreciate the underlying value the company has due to its assets or cash flows.

People often consider the two strategies distinct since stocks are often referred to as growth stocks or value stocks. When people refer to stocks like this, they are generally just referring to the expected growth of these stocks. When the market assigns a high Price to Earnings ratio, or PE, to a stock since it expects growth, people refer to the stock as a growth stock. If a stock has a low PE and a low book value, it is referred to as a value stock.

People often write about whether growth stocks or value stocks are better investments. While some of this writing has merit, a lot of it is nonsense. Just because a stock has a low or high PE does not make it a good investment. You need to look at the stock itself and decide whether or not the market is overvaluing or undervaluing the stock.

For example, let's say you know of a local restaurant that currently is trading at a PE of 17. The restaurant is a local chain and hasn't branched out much in the past 5 years. The market does not expect it to grow much because of this. However, you believe that due to the restaurant's new management, its growth prospects are widened. While it is a local restaurant now, you believe it can easily become a regional, perhaps even national restaurant.

In this scenario, you are buying a value stock because you believe the stock's growth is not appreciated by the market. While the stock's PE is about right if it in fact had no growth prospects, you believe it should be trading at a higher valuation since it in fact does have growth prospects. This is just an example of how you shouldn't consider growth/value as differing strategy, but just as components of finding stocks that are under appreciated by the market.

When you buy a growth stock, you are often betting that the stock will in fact grow quicker than the market expects. For example, if you buy a stock with a forward PE of 45, you are banking that not only will the company grow, the company will grow faster than analysts expectations.

However, you can still take into account value considerations when choosing to buy a growth stock. Let's take, for example, a restaurant trading at a 45 PE and a tech company trading at a 75 PE. In the case of the restaurant, it again is a hot local to regional chain that appears to be on track to being a national chain. In the case of the tech company, it is a start up internet site that is currently not making much money, but people believe the website will take off soon.

The assumptions in the two scenarios are very different. In the case of the restaurant, you are just betting that people will appreciate the restaurant nationwide and not just in one location. You are also betting that the restaurant is not a "fad" restaurant. Even if the restaurant does not do so well in its national expansion, it is still making considerable money. So if national expansion does not go so well, you will have to expect the PE to decrease and thus the stock's price to decrease. Nevertheless, you are looking more at 25%-50% downside at most.

In the tech company's case, you are totally betting on growth. The company does not make much money now, and the PE is based entirely on projections. There is a lot more risk here since the downside is near 100% if the website does not take off. Knowledge of the company and its industry is a must here. Just because the company has a high PE and more risk does not necessarily mean it has a higher potential for a return as well. It could be that people have priced in success too much into the stock without appreciating the downside.

In the above scenario, both growth companies have excellent growth opportunities and a high potential return. However, the restaurant has less downside since it has more intrinsic value than the tech company. Thus, the value aspect of the restaurant may make it a better investment than the growth company. Of course, these examples are totally fictional, but they serve to illustrate a point in how you should use both growth and value principles whenever you make a long term investment.