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TAG | Value investing
6
Why You Should Invest in Growth, Not Value
0 Comments | Posted by Alexander Green in Alexander Green
Why You Should Invest in Growth, Not Value
by Alexander Green, Investment U’s Chief Investment Strategist
Monday, December 6, 2010: Issue #1401
Patrick Henry famously declared that he knew no way of judging the future but by the past.
So if you’re putting together a long-term investment portfolio, it might be wise to look at the historical returns for various types of assets. Not just for the past few years, or for several decades, but for the past couple centuries.
When you do this, you’ll notice something interesting:
- Owning a portfolio of businesses (stocks) has generally been much more rewarding than making loans to corporations or Uncle Sam (bonds) or sticking your money in the bank (cash).
- Look closer at the clear winner (equities) and you’ll also find that value stocks have outperformed growth stocks over the long haul and that small-cap value has beaten large-cap value by a substantial margin.
It therefore follows that an investor seeking maximum capital appreciation might focus on identifying undervalued small-cap stocks.
But there’s only one problem with this: It won’t work for most investors, even if the future is very much like the past. Here’s why…
Beware the Value Investing Trap
Value stocks require something that growth stocks don’t: Patience.
When a stock – either large or small – is in the cellar, it’s there for a reason. Typical ones are that the company is:
- Losing market share…
- Seeing its margins fall…
- Is losing money…
- Or is experiencing flattish sales and declining profits.
As a value investor, you don’t know when these state of affairs will end, but you might be tempted to invest in a company if it’s relatively cheap in relation to sales, earnings or book value (i.e. net worth) in the hope that management will set things right.
The problem is this can take quite a long time. Or it may never happen at all. As the stock gets cheaper and cheaper, you may believe it’s becoming an even better bargain. This is the classic “value trap.” And if you keep buying a stock on the way down, it may very well have your name on it when it hits rock bottom.
Dead Money With Decent Dividends
Even if a value stock is destined to generate a good return over, say, a three- to five-year horizon, most investors won’t be around to enjoy it.
How do I know this? Because as a former money manager, I’ve dealt with thousands of “typical investors.” And regardless of what they say in their initial interview about their willingness to stay the course and think long-term, it all goes out the window for 90% of them when the road gets bumpy. Or if things don’t kick into gear right away.
A client who sits on a stock – or even a stock fund – for six months and doesn’t see a spark will remind you with every conversation that he or she is sitting on “dead money.”
No argument there – they are (at least temporarily). But value stocks often pay decent dividends that help compensate for this. Early in my career, however, I got tired of holding hands and counseling patience and switched from a value to a growth methodology.
It was a good move. If you want action, you should have it…
There’s No Shortage of Excitement with Growth Stocks
Buy the best growth stocks you can find. Given that they tend to be twice as volatile as the market (and twice as expensive), there is generally no shortage of day-to-day excitement.
But if you use a trailing stop, you can generate results that are much better than historical long-term returns (which always assume a buy-and-hold approach) and with less risk because your positions are fully protected.
So unless you have the patience of Job – and most investors don’t – you’re better off owning growth stocks than value stocks and, of course, using a trailing stop.
In my next column, I’ll demonstrate why small-cap growth – historically the worst-performing long-term equity class – is the very best place to find blockbuster stocks.
Good investing,
Alexander Green
18
Why Value Investing and Trading Don’t Mix
0 Comments | Posted by Alexander Green in Alexander Green
Why Value Investing and Trading Don’t Mix
by Alexander Green, Chief Investment Strategist
Tuesday, May 18, 2010: Issue #1262
Last week, I spoke at a special conference on value investing at the beautiful Driskill Hotel in Austin, TX.
Virtually every stock market investor talks about “recognizing value.” I’ve found that interest in value investing ebbs and flows depending on the market. No one wants to overpay for a stock, or keep holding one if the price gets nutty.
And that leads to a basic question: How do you find value in the stock market?
It depends whom you ask…
The Fathers of Value Investing
The fathers of value investing, of course, were Ben Graham and David Dodd, two teachers at Columbia Business School who wrote the investment classic, Security Analysis.
They argued that value investing is about buying companies that are selling below their intrinsic value.
How do you determine that? According to Graham & Dodd, that means buying companies that…
- Trade at significant discounts to book value.
- Have high dividend yields.
- Have low price-to-earnings (P/E) ratios.
Buying this way is not only supposed to lead to higher returns. It’s also designed to provide a significant “margin of safety.” The idea is that if you buy a security right, your downside is limited.
A number of academic studies have shown that if you follow the principles of Graham and Dodd, you should do very well over the long term.
But there are potential problems with this approach…
Don’t Let a Cheap Stock Suck You In
First of all, stocks are rarely as cheap as they were back in the 1930s when Security Analysis was written. Or even as cheap as they were back in 1982 when the typical stock sold for less than book value and eight times earnings and yielded more than 6%.
And if you sat out the last 28 years out because stocks were too expensive, you missed an awful lot of opportunities.
When you do find a stock that does meets Graham and Dodd’s stringent requirements, you also need to be patient. Why? Because companies that are very cheap are out of favor for a reason. Sales are often flat or down. Earnings are weak. Profit margins are low.
You can’t succeed just by buying a company that’s cheap. (It can always become cheaper.) You have to buy a company that will someday – and perhaps not too far off – be dear to others. Otherwise, when will you take profits?
So maybe Graham and Dodd’s message needs modifying. (Warren Buffett, Graham’s most famous student, has certainly found ways to modify it.)
The Problem With Defining “Value”
I’ve found that the definition of value and the tools to achieve a margin of safety are flexible. And The Oxford Club has found successful ways to bend them.
To my mind, any stock that goes from $10 to $50 was a “value” at $10. I don’t care what the P/E or price-to-book was at the time. With the luxury of hindsight, it was clearly a bargain. Why quibble?
But die-hard value investors will argue that if the stock was “overvalued” at $10, it’s only more grossly so at $50 – and therefore, you’re at great risk holding it.
I disagree. If you use our customary trailing stops, your upside is unlimited and your profits fully protected. As long as a stock keeps trending up, we’re content to hold on – no matter what the valuation. When the stock eventually turns, as all do eventually, our stops will keep the profits from slipping through our fingers.
As for value analysis, quite frankly, we don’t spend a lot of time poring over P/Es and book values. We’re just interested in identifying companies that are likely to show dramatic, better-than-expected growth in the quarters ahead. These stocks tend to be more expensive than average, just as companies that will show little or no growth tend to be cheaper than average.
This method works, too…
Do You Have the Key Traits to Profit From This Approach?
The independent Hulbert Financial Digest has ranked our Communiqué among the top five newsletters in the United States for 10-year performance.
And our approach has one significant advantage over value investing. It works quickly.
- Growth stocks tend to sprint.
- Profits often come sooner rather than later.
As someone who spent 16 years as a money manager, I know that most investors don’t have the patience to be good value investors. (John Templeton, for instance, held companies in his flagship Templeton Growth Fund an average of 7.5 years.)
Yet clients will start to grouse if a stock doesn’t move for six months. They call it “dead money” and start itching to move it elsewhere.
I understand this instinct. But deep value investing and rapid trading don’t mix.
If you’re a patient, truly long-term oriented investor, value investing can work wonders. If you’re not, you’ll be better off searching for companies that are set to smash estimates.
When a stock doubles or triples – or rises 50-fold or more like Apple (Nasdaq: AAPL) and Amazon (Nasdaq: AMZN) – don’t worry, other investors will concede it was a “value” before.
Good investing,
Alexander Green
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