Beginners Guide to Investing Strategies
Comparing the value, growth and dividend investing strategies.
In this post, we’ll take a look at:
As beginner investors dig deeper into investing they usually stumble across the terms “value investing”, “growth investing” and “dividend investing”. Those terms refer to some of the most popular investing strategies which are being employed by professional investors. This article takes a deeper look at those strategies and explains their key differences.
Value Investing
The value investing strategy is most famously known for making Warren Buffett one of the most successful investors alive. It involves researching and purchasing companies with solid fundamentals which are being sold below their intrinsic value. Those are generally solid businesses which have fallen out of favor. Once the companies stock price reaches above its intrinsic value value investors sell their investments at a profit. Hence value investing can best be described as buying low and selling high.
The intrinsic value of the company is calculated using the balance sheet of the company. It generally represents the value of all remaining assets the company owns after all of its liabilities have been payed off.
In addition the past and current earnings are evaluated to determine whether the company is sustainably earning money. A key indicator for this is the price-to-earnings ratio (in short P/E ratio) which indicates how expensive the company is compared to its earnings.
However not every company which appears to be cheap is a good investment. A company with a low P/E ratio might turn out to be a value trap which suffers from financial instability or has little growth potential.
Sometimes value investor also invest in declining or bankrupt companies as they expect to get more money out of the liquidation process than the investment they made.
If you want to learn more about value investing we recommend you to check out our review of “The Little Book of Value Investing”.
Growth Investing
While value investing is based on the past and present state of a business growth investing focuses on how much growth the company can achieve in the future. Growth investments tend to be smaller, younger or unprofitable companies. However there are also a few established growth companies such as Microsoft or Amazon.
Often growth companies are said to be “priced for perfection“. Their stock price is often more volatile than that of a value company as there are higher expectations attached to that company. Compared to value stocks, stocks of growth companies tend to loose more value in case of bad news and gain more value in case of good news. Unprofitable growth companies are missing their P/E ratio while growth companies with low but positive earnings tend to have high P/E ratios. As such they are often the more expensive stocks compared to value stocks.
Another important aspect to consider is the cash runway of the company. It indicates how much money the company has left to finance its operations in case it operates at a loss. A growth company should have a sufficient cash runway to ensure that it can maintain its growth rate without running out of money.
One growth investing variant which seeks to combine growth and value investing is called growth at a reasonable price (also known as GARP). Investors following this strategy seek to invest in companies with a high growth potential which are still being traded at low P/E ratios.
Dividend Investing
Dividend investors focus on investing into companies which have a stable track record of paying out dividends. A dividend is a part of the companies earnings which is being distributed to its shareholders. Those dividends usually are paid in regular intervals, usually monthly, quarterly or yearly.
A key criteria for dividend investors is the dividend yield. It indicates how much a company pays out to its shareholders compared to its stock price. The higher the dividend yield is the more dividend investors get paid out.
A stable record of past dividend payments is another important criteria. If a company has a stable record of dividend payment the likelihood is higher that dividend payments will be made in the future. Ideally the dividend yield is rising in regular intervals to combat inflation. In general dividends should not be financed using debt as that risks the long-term viability of the business.
Conclusion
As this article about the difference between growth and value stocks by Merrill points out growth stocks tend to perform better in bull markets while value stocks perform better in bear markets. This is confirmed by Christopher H. Browne in his book “The Little Book of Value Investing”. So in conclusion value investing could be described as a slow and steady way to grow wealth while growth investing can lead to faster gains but also bigger losses. In comparison dividend stocks tend to have more stable stock prices and as a result their primary gain comes from their dividends.
In the end it depends on the risk tolerance of the investor. For example a young person might have a higher risk tolerance and could benefit from growth stocks while value and dividend stocks would be more suited to investors with lower risk tolerances.
Keep On Reading
Learn more about fundamental investing concepts in this recommended post.
