Choosing between Value, Growth or GARP:
Stock-picking is a process wherein you conduct a systematic analysis to select a few stocks to add to your portfolio that will prove to be a sound investment. At the time of stock-picking, you may have come across the investment styles i.e. value investing and growth investing. You may wonder what these styles are and how these differ from each other. Moreover, which of these styles would provide you with a higher return on investment?
Some believe that growth investing is better than value investing, while the others perceive the opposite to be true. Whichever method you may adopt, if you understand the basics of stock-picking along with the business model of the company, then surely your returns are going to escalate.
The following article highlights the differences in these two approaches based on fundamental parameters:
Growth investing focuses on the comparison of current share price with the historical share price to analyse the growth potential of the company. It encompasses picking up those stocks which are trading at a higher share price and characterised by a rapid growth in the revenues. It extensively relies on forward earning projections to finalise an investment decision. At this point, one thing needs to be emphasised. Just relying on growth estimates without understanding the life-cycle concept of the company will not enable you to appreciate and implement growth investing. Usually, the growth rate of large-caps will be lower as compared to small-caps. That is why before investing, you should know what is the market capitalisation of the company, at which stage of the life-cycle is the company operating and growth potential of the industry as a whole.
Growth investing involves doing inter-firm, intra-firm and industry-firm comparisons. In order to qualify for investing, on the whole, a company should be able to outperform at least past five-year average performance in addition to its competitors’ performance and industry’s average performance. The prices of growth stocks are expensive as compared to prices of value stocks. You may find growth companies especially in the information technology industry wherein these companies continuously innovate and deliver new technology to outperform the competitors.
Growth investing believes in efficient market hypothesis and considers that market prices reflect the real worth of the company. It is based on the assumption that when a company consistently experiences growth in its earnings over the past 5-10 years, then it’s going to replicate such performance in the ensuing ten years. As a result, this growth automatically makes its market price buoyant. Additionally, if it exceeds its past five-year profit margins and return on equity, only then it qualifies to be called as a growing company.
Growth stocks comprise those companies that have a high growth potential but are comparatively younger than value companies. These companies do not distribute dividends. You, as an investor, make profits out of capital gains when the company reinvests its earnings which cause its share price to surge in the capital market. As compared to value companies, these companies have high P/E ratios and their stock prices tend to double in every five years.
Value Investing is a stringent screening process to determine the intrinsic worth or actual value of the company. It is done to establish its merit for putting your money into the company. In addition to earnings, value investing makes use of company fundamentals like cash flows, book value and dividends for calculating the intrinsic worth of the company. After arriving at the actual intrinsic value, you compare it to the current share price rather than with the historical stock prices. External factors like market volatility are perceived not to influence the long-term value of the business. Propagators of this investment strategy are Benjamin Graham, David Dodd, Warren Buffet, etc.
It disregards the efficient market hypothesis claiming that stock prices do not always reveal the real worth of the company as there are tendencies of the market to assign an incorrect price to the stock. Usually, a company having a high beta is looked upon as a risky investment. But, in the case of value investing, high beta won’t make much difference in your investment pattern if you consider your intrinsic valuation to be correct. However, you need to keep some margin of safety i.e. leave some scope for error in estimation.
Value stocks comprise well-established companies the share prices of which trade around 2/3rd of their real value.The logic assigned for this phenomenon is that there lies some fallacy in the market valuation which results in an undervaluation of the shares. But as soon as the market corrects its inefficiencies, the share prices of value stocks will rise owing to strong fundamentals of the company. These companies usually pay regular dividends to investors. These companies are characterised by low P/E ratio and low price/book ratio. The debt-equity ratio is less than one while the liquidity ratio tends to be around 2.
Both of these strategies may seem poles apart to you. If you are the one who would like to follow the middle path rather than become totally value investor or growth investor, then there’s a third kind of strategy for you called Blended Strategy of GARP (growth at reasonable prices).
Blended Strategy or GARP (growth at reasonable prices)
GARP strategy is about picking the undervalued stocks that exhibit viable growth potential in the long run. It draws upon heavily from value investing and growth investing strategies. Peter Lynch is looked upon as one of the greatest advocates of GARP philosophy. On the similar lines of growth investing, GARP also involves picking only those stocks that have witnessed positive retrospective earnings and hold the capability to deliver positive earnings in future. Additionally, it requires the stocks to have a positive and growing RoE which is more than the industry RoE. However, as far as growth rates are concerned, GARP strategy looks for stocks displaying moderate growth rates because stocks experiencing extremely high growth rates are perceived to be risky in this strategy.
On the similar lines of value investing, GARP strategy looks for stocks that have a low P/E ratio and low P/B ratio as compared to the industry average. So, the strategy focuses on selecting stocks that have good growth rates but at the same time are available at reasonable prices.
In a nutshell, growth investing helps you to make unbeatable returns during bull runs on the other hand value investing contributes to earning high returns during bearish market conditions. GARP may not give extremely high returns during bullish conditions. However, in bearish times, you are going to earn more than value investor and make fewer losses than growth investors. Ultimately, the blended strategy would provide you more consistent and predictable returns. So, before actually jumping to GARP strategy, you need to master value and growth strategy.