Which of These Four Investing Strategies is Right for You?
by Marc Lichtenfeld, Advisory Panelist
Wednesday, August 4, 2010: Issue #1316
What's your investing style?
Are you a value investor - grouped in with heavyweights like Warren Buffett and John Templeton?
Or do you prefer a growth investing model - alongside guys like Peter Lynch and William O'Neil?
Supporters of each approach are as vocal about their theories as the bulls and bears are about theirs.
Each side can point to statistics that prove their view is the correct one. Toss in contrarians, believers in GARP (Growth At a Reasonable Price - more on this in a moment) and various other methods of investing and it becomes a dizzying cacophony that leaves an investor wondering which approach is best.
So let's weigh up the pros and cons of these four styles...
Value Versus Growth: A 10-Year Breakdown
No matter what investing method you use, you're going to see periods where your approach outperforms or underperforms the market, or just bounces along at the same pace.
For example, over the past 10 years, the MSCI US Prime Market Value Index has posted a compound annual return of 2.97%, comfortably beating the MSCI US Prime Market Growth Index, which lost 4.33%.
Over the past three and five-year periods, however, growth outperformed value. And over the past year, value stocks are edging out growth, but by less than 1%.
Let's dig deeper...
Four Investing Styles: Which One is Right for You?
Breaking down each of the four approaches...
- Value Investing: It's hard to argue with the success of Warren Buffett, John Templeton and Martin Whitman - famous value investors who've made fortunes for themselves and for their clients.
Value investors look for companies trading at less than their intrinsic value. They tend to like companies with low price-to-earnings, price-to-sales and price-to-book ratios. You often find that value stocks boast high dividend yields because their share prices have fallen.
When I first got involved in the markets, I was a value investor. It taught me to be patient, as it tends to take time for the market to realize the full worth of value stocks. However, that patience is usually rewarded, as the gains can be significant once the stocks become fully valued (or overvalued).
As my career evolved, though, I shifted more towards growth stocks...
- Growth Investing: Growth investors aren't as concerned with P/E ratios or other valuation metrics as much as they are with a company's growth prospects.
Growth stocks tend to be smaller and are a bit riskier because if the projected growth doesn't materialize, the stock can get punished. Of course, growth stocks can seemingly rise forever if they continue to hit or exceed growth projections - my colleague Alexander Green discussed Apple as a perfect growth stock a few of weeks ago.
- GARP (Growth At a Reasonable Price): This is a blend of value and growth. GARP investors want growth, but will only pay what they consider a reasonable price.
As a result, perhaps the most important valuation metric is the Price/Earnings to Growth ratio (PEG).
|Price/Earnings to Growth ratio (PEG)This is a way of calculating a stock's value while factoring in its earnings growth.
You do this by dividing the price-to-earnings ratio (P/E) by the stock's annual earnings per share growth rate.
By taking growth into account, the PEG ratio is widely considered a more accurate reflection of a stock's true value, rather than just the P/E ratio.
Using the PEG ratio is easy. A PEG of 1.0 means the market considers the stock to be fair value. A PEG under 1.0 means the stock is undervalued, while a PEG over 1.0 means the stock is overvalued.
Typically, a GARP investor will insist on a PEG of 1.0 or less. That means the P/E ratio will be lower than the growth rate.
A current example is BMC Software (NYSE: BMC). With a forward P/E of 12 and a five-year expected annual growth rate of 15, the stock trades at a PEG of 0.75.
- Contrarian: Investors who use this method need to have nerves of steel. They buy stocks that Wall Street and mainstream investors shun.
Contrarians need to be extra diligent in their research in order to find viable reasons to invest in unloved stocks. It could be that the companies in question are worth more than their market caps, due to factors like over-zealous sellers after bad news, or that Wall Street is just ignoring a company's potential.
Contrarians have to be able to not only go against the majority of investors, but also have patience to see their investment thesis realized.
David Dreman is one of the most famous contrarian investors, having written the bible of contrarian investing, Contrarian Investment Strategy: The Psychology of Stock Market Success, as well as two follow-ups. They're must-reads for any investor, but particularly those who consider themselves contrarians.
So which of these four investing approaches is right for you?
Investing with Style... Every Style
The answer should be all of them.
Just as you'd never load your portfolio with only technology stocks or only gold stocks, it shouldn't contain only value or growth stocks.
Remember that various approaches dip into and out of favor, just like various sectors and stocks.
So if picking value stocks is your thing, that's fine. Just be sure to add a good growth stock mutual fund or ETF to your portfolio to balance it out. That way you'll have exposure to what ever is working at that moment.
Hoping your longs go up and your shorts go down,