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Valuation and Growth Versus Value Investing

You must have heard a lot of talk about growth investing and value investing all of which may have left you bewildered and confused. To properly understand the basics of growth and value, you must first understand that despite the claims of economists, there is no such thing as a perfectly efficient market. If markets were perfectly efficient and adjusted instantly to any kind of discrepancy in prices, stock picking would be a futile exercise because you cannot expect higher than average returns. Again, if efficiency was the norm, there would be no particular advantage in pursuing a growth strategy over a value investment strategy or vice versa.

On the other hand, if we understand why the stock market tends to price stocks wrongly, we can better understand growth and value. In this context, you can view growth investing as a strategy which believes that the market is prone to undervaluing stocks that have high growth prospects. These stocks are normally characterized by price/earnings ratios because the market expects earnings to grow rapidly. Because growth investing involves the belief that the market is pessimistic when it comes to high-growth companies, a growth investor may choose to concentrate on stocks with high price/earnings ratios.

The value investor tends to believe that the market undervalues companies with low growth prospects and sometimes believes that he has a special knack of evaluating these companies. The value investor then proceeds to eliminate stocks with high price/earnings ratios and concentrate on stocks with low ratios. However, there is no evidence that one strategy is better than the other when it comes to superior returns.

It is worth pointing out that regardless of growth or value strategies, successful stock picking of any kind hinges on identifying undervalued stocks. Successful growth investing consists of identifying undervalued growth stocks while successfully value investing consists of identifying undervalued value stocks and, as you can see, the difference is actually not important. What you need to take away from this is that, regardless of the style that you adopt, the valuation techniques and tools used for success are pretty much the same. In other words, the exact distinction between value and growth investing is meaningless to the shrewd investor.

Stock pickers generally adopt one of two approaches when it comes to valuation. One of them is a bottom up approach where the evaluation of a particular company is based on a comparison with its peers. In other words, the focus is not on a particular industry or business but the relative position of a particular company within that industry or business. Another underlying principle is that investment in particular stocks in a diversified set of industries is a good route to success. The other approach is top-down where the economic factors relating to the prosperity of a particular industry are first identified and this helps in establishing which particular industries are likely to be undervalued. Once this is done, you can proceed to identify promising companies within that particular industry. Either approach is good provided your objective in identifying undervalued companies is achieved. Sometimes it is not a bad idea to use both approaches so that you can verify your stock picking with the results of the other approach.