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Growth and Value: Two Paths to Equity Investing

Growth investment style seeks companies whose earnings are expected to grow faster than the broad market.

Value investment style seeks stocks that are believed to be priced below the companies' actual values.

What differentiates a growth stock from a value stock?

While there is no universal formula for determining whether a stock should be categorized as growth or value,an analysis usually begins with the stock's price/earnings (P/E) ratio and/or its price/book (P/B) ratio.

•   The P/E ratio is the current stock price divided by current earnings per share (i.e., the multiple of earnings

at which the stock is selling).

•   The P/B ratio is the current stock price divided by the company's book value (total assets less total

liabilities).

Growth stocks typically exhibit higher P/E and P/B ratios, Value stocks are almost always lower.

Given all that's been said, one might suspect that growth stocks are expensive and value stocks are cheap. This

generally may be the case, but not necessarily. Consider a company with desirable products and reliablemarkets whose share price is depressed because conflict among management has hindered productivity. Even

at its lower share price, this is not a true value stock because the company is not fundamentally healthy and

its share price is unlikely to recover. Growth stocks can pose similar challenges to the style-minded investor,

as they can sometimes sell quite cheap relative to their earnings potential. The key to successfully navigating

these anomalies is to do research, recognize good investments when they come along and not miss out on

opportunities because of style labels.

Sometimes a growth stock can masquerade as a value stock. For example, say a relatively new company has

developed a promising piece of technology. The company's stock may be undervalued for a time because

investors are wary of the company's short track record, or perhaps they simply haven't yet recognized the

growth potential of the new technology.

General Characteristics/Risks of Growth and Value Stocks

Growth Stocks Value Stocks

Characteristics

•   High rate of growth in earnings/sales•   High price/earnings and price/book

ratios

•   Pay lower or no dividends

•   Lower rate of growth in earnings/sales

•   Low price/earnings and price/book

ratios

•   Higher dividend yields

•   Turnaround opportunities

Risks

•   Future growth does not occur as

expected

•   Price/earnings or price/book ratios

decline unexpectedly

•   Evaluation of stocks as "good value" is

misread

•   Difficult to stick to value policy when

prices are beaten down

10 February, 2012

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Growth and Value: Two Paths to Equity Investing

contd.

Variations on Growth and Value

Value investors use methodologies based on the original teachings of Benjamin Graham and David Dodd.

Graham and Dodd were professors at Columbia Business School who pioneered value investing in the 1920s.

Today, some investors focus on absolute value (as measured by P/E and P/B ratios), while others look for

relative value. A relative value approach may compare a current indicator like the P/E ratio to the

company's own historical P/E ratios, or to the ratios of other companies in the same industry. Using a

relative value approach, it is even possible to find growth stocks that are relatively undervalued versus

their peers.

There are also different approaches to growth investing. The core growth philosophy argues that a highstock price does not matter if the company's growth prospects are sufficient. Some investors, however,

take the view that a growth stock is only worth buying if the price is reasonable. This approach, known as

Growth at a Reasonable Price (GARP), is essentially a hybrid of growth and value investing.

Selecting stocks based on a single measure, such as its P/E ratio, can be very risky. Most large-scale

investors and fund managers of both styles rely heavily on fundamental research to uncover strong

companies that represent good investments.

So which style is right for your portfolio?

The answer is: both. Value and growth stock performance moves in phases because the business cycleaffects growth stocks and sectors differently than it would their value-oriented counterparts. Since it is

very difficult to predict when the phase will change, it is important to own both value and growth stocks in

a diversified portfolio. Diversifying across equity styles may also help to mitigate some of the risk of 

investing in either of these asset classes in isolation. Historically, growth stocks have performed better

when the economy was prospering, while value stocks tended to take the lead when the economy was in

the midst of, or climbing out of, a recession.

Growth and Value Mutual Funds

Since even the professionals can't agree on hard-and-fast guidelines to identify growth versus value stocks,

it can be especially difficult for an individual investor to achieve a balanced portfolio with adequateexposure to the two styles. One excellent way to achieve such diversification is by investing in  growth- and

value-styled mutual funds. Fund managers have extensive research capabilities, and the size of a mutual

fund allows it to hold a more diversified group of stocks than an individual can usually afford.

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