The plethora of choices available to stock investors can seem bewildering at first blush. Some 14,000 companies trade in U.S. Dollars on American stock exchanges and thousands more in their native currencies on foreign bourses. Large cap, small cap, international, domestic, high-octane or steady Eddie; sometimes the mind reels. A good starting point is to separate the choices into basic style categories seeking to broadly describe the general tenor of each potential investment.
Equities are traditionally divided into two style categories: growth and value. While there are other possible classifications and many shades of grey, this broad distinction is useful in assessing the appropriateness of an individual stock or stock fund with regard to a particular investor's goals and risk tolerance.
Growth investing focuses attention on what prognosticators believe the future holds. Growth investors generally seek to identify stocks whose "intrinsic" or fair market value is expected to rise over time in response to projected increases in sales and profits. Fundamental financial analysis is often less important than upward momentum and economic trend forecasting. Growth companies tend to pay out a smaller portion of their earnings in dividends, retaining that capital to reinvest back into stimulating more growth and expansion to drive the stock price higher. This concentration on expansion at the expense of distributions imparts somewhat higher volatility on average but can also result in bigger gains during favorable periods.
Standard & Poor's Corp.bifurcates its well-known S&P 500 market index into a separate growth component and a value component. Criteria for classification as a growth stock include projected sales expansion, estimated forward earnings increases, and recent stock price momentum. The S&P growth index includes companies like Apple, Microsoft, Facebook and Google.
Value investing looks at the world from a different perspective. The value approach focuses more intently on analysis of a firm's current financial position in an effort to spot potential inefficiencies in pricing. This style seeks to find companies whose current stock price is significantly below the intrinsic or fair value as estimated by the investor, seeking to profit as the rest of the market recognizes the underpricing and bids up the market price.
Stocks that fall into the value camp tend to be somewhat less volatile on average than growth stocks. Furthermore, they generally pay higher dividends as a group than their growth stock cousins as more capital is allocated to shareholders and less to internal expansion.
S&P classifies stocks into its value bucket according to time-honored valuation metrics like the price to book value, price to sales ratio, and the price to earnings ratio (P/E). Stocks that populate the S&P Value index include GE, Berkshire Hathaway, Pfizer and Exxon.
Which style is best? It depends. Many fundamental analysts lean toward a value orientation. Historically, returns to value investing have exceeded growth by one to two percentage points per year on average. However, there have been significant periods of time during which growth outperforms, including the tech boom of the 1990s and the post-recession rally since 2009. Thanks to a higher average dividend yield and diminished volatility, value investing is often favored by more risk-averse stock investors and by those seeking to generate cash flows to meet known expenses. A hybrid style known as "growth at a reasonable price" or GARP is really just a repackaging of the value approach focused on companies that are undervalued but have expansion prospects.
First and foremost is the need to set goals and assess risk tolerance. Only then should a consideration of the appropriate style (or mix of styles) be undertaken.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.