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Which is the best investment style?

May 01, 2007 09:52 IST

One of the most important developments in equity management during the last decade has been the creation of portfolio strategies based on 'value' or 'growth' oriented investment style. It is now common for money management firms to define themselves as 'value stock managers' or 'growth stock managers' when selling their services to clients.

The distinction between value and growth investing can be best appreciated by considering the thought process of a representing manager of each style.

Growth stocks are companies that will have positive earning surprises and above average risk adjusted rate of return because the stocks are undervalued.

Value stocks are those that appear to be undervalued for reasons other than economic growth potential. Analyst identifies value stocks as stocks having low P/E or low P/BV. In this article we try to look into how a value investor and growth investor looks at the PE ratio.

Price to earnings ratio is defined as: Current price per share/earnings per share.

Where EPS measure can be based on either current or future performance of the firm. In broad terms, value and growth managers will focus on different aspects of this equation when deciding whether a stock should be added to an existing portfolio.

Specifically a growth-oriented investor will:

  • Focus on EPS component of a PE ratio and its economic determinants.
  • Look for companies that expect to show rapid EPS growth in future.
  • Assume that PE ratio will remain constant over the near term meaning that stock price will rise as forecasted earnings growth is realised.

On the other hand, a value investor will:

  • Focus on price component of a PE ratio. He must be convinced that the price of the stock is cheap by some means of comparison.
  • Not care a great deal about the current earnings or fundamental driver of earnings growth.
  • Assume that the PE ratio is below its natural level and that the market will soon correct this situation by increasing the stock price with little or no change in earnings.

In summary the growth investor focuses on the current and future economic story of a company with less regard to valuation. The value investor, on the other hand, focuses on the share price in anticipation of a market correction and possibly improving company fundamentals.

The conceptual difference between the value and growth investing may be reasonably straight forward, but classifying individual stocks into appropriate style is not always simple in practice. Since detailed company valuations are time consuming to produce, analysts rely on most easily obtained financial indicators- such as P/E, P/ BV, Dividend yields and EPS growth rates- to define both an individual equity holding and style of benchmarking portfolios.

Although investors appear to pay somewhat more attention to growth-oriented strategies, research has shown that a value approach to portfolio management tends to provide superior returns. It is tempting to conclude that value is unambiguously superior to growth as an investment style. However it is important to note that, although value investing produces higher average returns than growth investing, this does not occur with much consistency from one investment period to another.

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