Page 26 - DIY Investor Magazine | Issue 41

INVESTING BASICS: GROWTH OR VALUE INVESTING?
· August 2024 26
DIY Investor Magazine
Whatever style an investor adopts, the goal is always to identify and buy an asset in the hope and expectation that its price will increase; whilst the ambition may be simple enough, its achievement may be altogether trickier – how do you judge whether your investments are positioned to get the best possible return? – asks Christian Leeming.
So, what are growth and income investing, and what’s the difference?
According to Investopedia: ‘Growth and value are two fundamental approaches, or styles, in stock and stock mutual fund investing. Growth investors seek companies that offer strong earnings growth while value investors seek stocks that appear to be undervalued in the marketplace.’
Growth investors buy companies that are growing their revenue, profits or cash flow at an aboveaverage rate, whilst value investors look under the bonnet, hoping to unearth stocks that the market has undervalued.
In truth, adopting an investment style is rarely binary; investing styles are not mutually exclusive, real life investors may adopt either a growth or value approach according to individual circumstances.
WHAT IS GROWTH INVESTING?
Growth investors buy young, early stage companies seeing rapid growth in profits, revenue or cash flow; they prefer capital appreciation, or sustained growth in the market val- ue of their investments, rather than the steady streams of dividends sought by income investors – the so called ‘Magnificent Seven’ - Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla – have handsomely rewarded growth investors.
UK equity markets have been unloved – so potentially
a happy hunting ground for value investors – but Motley Fool currently offers up 3i and BAE Systems as must have growth stocks.
Key to understanding growth investing is to understand
the life cycle of companies. Early on, a new company may grow quickly, generating rapid gains in revenue and profits; which it typically reinvests into the business to drive further growth, rather than pay dividends.
As the company, and its market, matures, growth in revenue and profit slows; when it is fully mature, growth slows further. At this point, companies tend to distribute profits to investors in the form of dividends as investment opportunities in their markets diminish.
GROWTH AT A REASONABLE PRICE (GARP) INVESTING
When analyzed with standard valuation metrics, such as the price-to-earnings (P/E) ratio, growth companies often appear expensive; in some cases, astronomically so – in mid-September 2020 growth investors’ darling Amazon had an astonishing P/E ratio of 128.
Growth investors look beyond current expensive valuations to even greater expected future growth; whether a ‘growth at any price’ approach to investing is sustainable is debatable, so some investors, including famed investor Peter Lynch, popularised a strategy that looks for reasonably priced growth companies called GARP investing.
GARP investors balance growth against high valuations by seeking growth companies priced in line with their intrinsic value; Investopedia – ‘Intrinsic value is a measure of what an asset is worth. This measure is arrived at by means of an objective calculation or complex financial model, rather than using the currently trading market price of that asset.
The key challenge is to forecast a company’s growth prospects; predicting future growth with any degree of certainty for younger companies in fast-changing industries, can be very difficult. And even if they get it right, how much should they reasonably pay for that growth?
GARP investors use a ‘PEG’ ratio to determine if a company is reasonably priced given its growth prospects, which is calculated by dividing the P/E ratio by the expected growth rate of a company.
A ratio of one or less indicates that the stock is reasonably priced; above one says the stock is too expensive.
For example – Acme Media trading at £100 per share, with earnings of £10 per share and expected growth rate of 20%; PEG ratio = 0.50 (£100 / £10 / 20) and considered reasonably priced for a GARP investor.