Determing your Investing Style

The first important step before making any investment is to determine your financial goals. The second step is to determine your investment style.

In this section, you’ll learn…

There are two basic styles of investing – value and growth
The differences between each investment style
Which investing style to consider as a beginning investor

There are two basic styles, or approaches if you will, to investing – value investing and growth investing.

Both value and growth investing, like market sectors, go in and out of fashion depending on the momentum of the market and which sectors of the market are in favor with investors.

The following graph shows the historical returns of both value and growth investing, and the periods that each were in and out of favor with investors.

A rule of thumb for deciding the percentage of your money you should have in growth investments is 100 minus your age. Forty years old? That means allocating 60 percent of your assets for stocks, real estate or small business investments.

Value Investing

If you like buying stuff on sale, you’ll love value investing. The idea is similar to trying to unearth designer labels in a discount store, or finding a marked-down last-minute vacation package.

Value investing is all about buying stocks that should be worth more than they are trading at in the current markets. The key measurement of whether a stock offers good “value” or not is through its price-to-earnings (P/E) ratio – a ratio used to evaluate a stock’s worth.

Value investors like to find stocks with low P/E ratios. But low is relative, of course. Value investors will measure a stock’s P/E against three benchmarks:

• The stock’s historical P/E ratio
• The P/E ratios of other similar companies
• The P/E ratio of the stock market as a whole

The P/E ratio compares a stock’s price to its share of a company’s profits. It is calculated by dividing the stock’s price by an earnings-per-share figure.

Growth Investing

In contrast to value investors, growth investors aren’t concerned about a stock having a high price-to-earnings (P/E) ratio.

As the name suggests, growth investors look for rapidly growing companies that exhibit both increasing sales and increasing profits, measured in terms of earnings per share (EPS).

Growth Factor #1: Increasing Sales

Growth investors like companies that have sold more in the last three months than the previous three months sales.

Because some businesses are seasonal, they’ll also look closely at how sales in a particular quarter are compared to the same quarter in the previous year. For example, it’s important when looking at a retailer that you compare a busy quarter such as the pre-Christmas season to the previous year’s pre-Christmas sales.

Growth investing is an investment style that looks for companies with above-average current and projected-earnings growth.

Growth Factor #2: Increasing Profits

Growth investors also look for growing profits. Ideally, profits will increase at a rate equal to the growth rate of sales. Of course, even better are profits that increase faster than sales. This means a company is increasingly able to pocket more of each dollar it takes in. This could be a result of growing economies of scale, a tighter hand on expenses, or finding a better, cheaper way to make or distribute products.

It’s precisely this desire for higher growth that usually means growth investors buy stocks with above-average P/E ratios. Companies that grow their profits at above average rates generally deserve a higher P/E ratio. Why? Investors are willing today to pay more for each dollar of current profit, because they anticipate that the company will earn even more profits per share down the road, leading to an even higher share price.

Growth investing is an investment style that looks for companies with above-average current and projected-earnings growth.

Value or Growth Investing: Which Style Is Your Best Bet?

If you had to pick one style, make value investing your starting point. As suggested by the name, you’re buying stocks that are cheap because they are out of favor. This makes them a more conservative bet because they have less room to fall. If the company runs into trouble or the economy falters and the stock markets dive, a value stock by definition generally won’t fall as fast or far as a growth stock. There is a discount already built into their price.

By contrast, growth stocks often have a good deal of optimism factored into their price. If they run into trouble, they can plummet. That’s not to say you shouldn’t ever buy any stocks using the growth approach. After all, they have the potential to significantly increase your returns.

Growth investors look for stocks with above-average earnings growth no matter what the price. Value investors look for stocks trading at a discount to their usual valuation.

As you become more experienced, you may want to use both styles. For example building a core portfolio of value stocks, and then adding some growth stocks. Sometimes it also makes sense to match the style to the sector. For instance, it’s often wise to choose consumer stocks on a value basis. By contrast, you’re often better off choosing high-tech stocks that meet the requirements of growth investing.

We’ll show you how to put both strategies to work when we start helping you assemble your portfolio at a later stage.

Growth investors look for stocks with above-average earnings growth no matter what the price. Value investors look for stocks trading at a discount to their usual valuation.

Emotion Is A Powerful Thing

When it comes to the market and how certain stocks and sectors fair, there is another variable besides company performance or the economy at play. It’s the psychology of the market – otherwise known as human emotion – and it can have a huge impact on a stock or sector’s performance.

Emotion can overpower logic at times, even in the stock market. Consider the following examples:

A particular company has a short prosperous or turbulent period; a new line of computers finds favor or rejection by consumers; a pharmaceutical company has regulatory approval of its new drug expedited or delayed; a company’s current growth is faster or slower than its competitors.

It’s factors like these that can cause investors to embrace or turn their backs on a stock, despite the fact that it may remain a strong investment choice over the long-term. When they do, the stock price rises or falls and so does its P/E ratio.

Sometimes it’s not a stock but an entire sector that gets marked down. When the high-tech sector was soaring, investors took their money out of other sectors such as the financial industry. Why? Because there’s only so much money to go around in the stock market and the more popular one sector becomes, the less interest there is in some others.

Value investors for example, don’t buy stocks with low P/E ratios betting that the conditions that caused them to go “on sale” will continue. What value investors bet on is that sooner or later, the stock or particular sector will have its “value” discovered by others.

As the stock or sector becomes more popular, prices will rise. As prices rise, so do the P/E ratios. At some point, value investors in this case will feel the stock is “fully valued” and will sell the stock or sector so they can move their money into other undervalued stocks.

Key Learning Points

• There are two basic styles to selecting stocks – value investing and growth investing. These investment styles trade turns going in and out of fashion depending on the momentum of the market, and which sectors of the market are in favor with investors.
• Value investing involves looking for stocks that are “on sale’. Beginning investors should consider value investing as their introductory investment approach. It’s a more conservative investment style and stock prices tend to fall less in a market downturn.
• Value investors search for stocks with low price-to-earnings ratios (P/Es). Value investors will measure a stock’s P/E against three relative benchmarks: the stock’s historical P/E; P/Es of other similar companies; and the P/E of the stock market as a whole.
• Growth investing is all about buying stocks in rapidly growing companies that exhibit both increasing sales and increasing profits.
• Growth investors look for companies with increasing revenues and profits. Because they expect a company to earn more profits per share in the future, growth investors are willing to pay for stocks with higher P/E ratios.
• Human emotion (or the psychology of the market) can also have a significant impact on a stock or sector’s short-term performance within the market.