Value Stock Investing Versus Growth Stock Investing

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In a previous article, I spoke briefly on diversification, hedging, focus investing, why most investors can't emulate Warren Buffett, and why you're probably putting your investments at unnecessary risk if you try to do so. This third and final article will discuss a major dimension of individual investment style: value investing versus growth investing.

While my previous two articles could be generalized to all investments -- common stocks, preferred stocks, bonds, money market instruments, derivatives, commodities, real estate and collectibles -- this one will be specific to common stocks.

What do the terms mean?

Value investing is a philosophy that looks for stocks that are already worth more than their asking price, based on the dividends a stock is already paying or on the book value per share. (Book value is the total value of a company's assets minus its liabilities, as estimated by accountants. Because it's traditionally a conservative lower-bound estimate, book value is usually lower than market value.) Value investors generally assume the stock's dividends won't grow much faster than inflation, and they see rapid growth as unsustainable.

Growth investing instead considers the way a company can expand and pay larger dividends in the future than it's paying now. Companies that have yet to pay a dividend are usually growth stocks. Profits that a company doesn't pay out in dividends can be reinvested to expand the business. Large market share is self-reinforcing, since it provides brand recognition and the financial hit-points to survive a price war. If a company's executives have made exceptionally good decisions so far, this may be seen as a sign that they're smart and talented and will continue to do so.

Which is better?

The current dividend-paying ability of a company has a value to the common shareholders. The growth of that ability, with the pursuant increase in future dividends, also has a value. The company's potential to liquidate later for more than its current market capitalization also has a value, especially if it is at risk of never paying any dividends. However, the latter two are inherently riskier, because they depend on certain events in the distant future. No matter whether one is a value or growth investor, both present and future value must be considered on a risk-adjusted basis, and everyone will put a different price tag on risk.

Some 'supergrowth' stocks, whose growth prospects temporarily exceed the required rates of return, may just be having said rates of return placed too low due to underestimated risk. Perhaps the reason that small-cap stocks have been found to outperform large-caps[5] is the market's failure to account fully for their added risk, and for the added effort needed to evaluate them. Growth investors must beware irrationally paying a premium for excitement (as occurs in outright gambling, and possibly the 1990s dot-com bubble) or bragging rights (which may be why the inaccessible, $80,000+ Berkshire Hathaway Class A shares, NYSE:BRK.A, have never been split) for stocks that will not meet their goals at a fair price.

I believe that value, growth or anything in between can be a viable approach, depending on the investor's level of risk aversion compared with the market, and his or her preference for dividends or capital gains (because of reinvestment risks and costs, or different tax consequences). However, in both cases, one must know enough to find the true value — to the particular investor, not only to the market — of all assets being purchased.

Also, one must have an open mind to investments not matching the strategy. There is no such thing as a good or bad asset, only a high-value or low-value asset. Very few assets are worthless, so (barring ethical concerns) almost anything may be suitable for any investor if the price is right, and anything is unsuitable if badly overpriced. To put it simply:

Anything can be overvalued, and anything can be undervalued.