In the investment world, there are two main conceptual strategies for selecting promising stocks for your portfolio. The general logic of both approaches is similar, but the criteria that they use are very different.
The value strategy implies finding stocks of mature companies that are for some reason undervalued in their current business capitalization in relation to their actual book value. Basically, investors are trying to find market inefficiencies where they can pay 90 cents on the dollar. This concept was popularized by Warren Buffett. It’s been in use for almost 40 years and has become a classic of investing. An example of value investing right now can be the post-pandemic purchase of airline or cruise stocks. These industries are currently greatly oversold and are likely to recover to their fair value following the recovery of passenger traffic.
As far as picking good growth stocks, you will need to find companies where their revenue and net profit have outperformed the market average, and most importantly, will continue to do so in the future. It is about finding a breakthrough company with a unique product or innovative technology. You will be searching mainly among small-cap and mid-cap businesses with growth rates of at least 20% per year. However, giants like Microsoft or Amazon also continue to grow at a commensurate rate, so their names often top the list of growth stocks. This strategy has gained popularity in recent years and is often contrasted with conventional value investing.
Assessing both concepts in terms of volatility risk, it is safe to say that growth stocks are a more aggressive option, as young companies are more susceptible to news and possibilities of drastic revaluations of the business value due to slower growth.
Unlike value stocks, growth stocks generally do not pay dividends, which makes a lot of sense since a young, rapidly growing business invests all of its free cash flow in the company’s expansion and growth.
Historically growth stocks have greater upside potential during times when rates are low and corporate earnings increase significantly. However, as they are more susceptible to volatility, growth stocks usually take the first hit in a general market correction. There is no question that value investing is less risky since mature companies (many of which pay dividends) will be sold by investors last in case of a crisis and that directly affects the magnitude of their ultimate drawdown.
There are also hybrid strategies. For example, GARP (Growth at a reasonable price) involves investing in fast-growing campaigns with strong fundamentals that are not too expensive.
Practice shows that combining the two strategies within one portfolio can have a synergistic effect and relieve the investor from the need to closely monitor market cycles. There have been extended periods in history when growth companies dominated the market as well as when the value stocks took over, so it would be a mistake to try to keep up with the volatile market or try to predict the future. A diversified approach is the cornerstone of a modern investor’s portfolio.