If you go by the conventional wisdom, investors come in two varieties.
On one hand, you have investors who ply their trade in the belief that the past performance of a stock has clues to its future performance. Technical investing, as it is commonly known, depends much on behavioral aspects of investing, with stock charts being the main tools of the trade.
On the other hand, you have investors who believe that investing success lies in researching the business of the company on a fundamental level, and digging deep into a business? ability to generate profits over a long term.
Fundamental investing is further divided into growth investing and value investing.
Traditional media, and indeed a surfeit of financial publications, both online and offline, take pains to point out the differences between the value investing and growth investing approach.
But at the root, all investing is value investing.
To understand this, we need to go back to the basic principles of fundamental investing.
Why do Investors Buy a Stock?
There is one and only one reason a fundamental investor buys a stock.
The expectation that the stock price will be higher in the future than it is today.
Since a stock is a part ownership in the business, the stock value rises over time as the business becomes more valuable by generating profits and positive cash flow.
Some investors are willing to pay a higher price for the stock today if they believe that the company will be able to generate growth at a fast clip over a sustained period of time. The growth investors may disregard current valuations if they believe that the future earning power is large enough that the business value will eventually catch up and surpass the current stock price.
Value investors on the other hand seek to buy stock in companies that have more tangible value today than the value market is ascribing to it.
They try to understand the reasons why the market is under pricing these companies, and if they determine that the market?s view of the company?s future is not warranted, they buy the stock.
Both the rational growth investor and the rational value investor concludes that the real value of the business is more that the current market price, and therefore the stock makes an attractive investment.
The growth investor may look at the ?potential? whereas the value investor may focus on the known or tangible sources of value, but essentially they are both making a value judgment for the business.
In Most Industries, Growth Means Squat. But in Some Cases, it is a Great Source of Value
Most industries in a free market economy are competitive. Which means that if the industry offers excess profits to the incumbents, there will soon be new entrants and the competition will rise to the point where profit margins will decline to a minimum for all industry players.
The only exceptions to this are the companies that are able to build up a sustainable competitive advantage around their product or service.
Competitive advantages come in many different flavors: brand loyalty (Apple, Coke/Pepsi, etc), regulatory advantages (such as patent protection for drugs, utilities, WD40, etc), cost structure (typically economies of scale that make new entry very expensive), network effect (eBay, Amazon), R&D (Intel), and to some extent product differentiation (Southwest Airlines).
Absent one of these competitive advantages, the rosy growth projections are almost always not going to be met. The so called first mover advantage only lasts a little while, perhaps even less than the time the company requires to reach profitability.
Growth only has value to an investor if the company is able to maintain or expand its profit margins.
In all other cases, growth actually destroys value as growth has to be paid for and the company is better off not growing (from an investors perspective) if this investment has diminishing returns.
The flip side is, that in situations where the company has a distinct competitive advantage, it can continue to grow and create more value for the shareholders.
Coca Cola (brand) and Intel (R&D) are classic examples. These companies can keep on growing by expanding into new products, new geographies, opportunistically pricing competition out of the market, and a variety of other means.
Sometimes A Growth Company Becomes a Value Investment
Growth companies can also become temporarily undervalued.
Even if a company is in an industry where creating a long term competitive advantage is not possible, the level of this temporary undervaluation may be severe enough to consider this stock as an appropriate value investment.
I recently screened for the best stocks to invest in for growing earnings and I came across a few such stocks in the memory chip sector. Most of the memory chip stocks that supply to the PC market have recently sold off due to ?sudden and surprise? revenue shortfall projections from the management due to an unanticipated deterioration in demand for the next year. What most investors missed however, is that the demand for memory chips has suddenly deteriorated because the floods in Thailand have shutdown most of the hard disk production capacity in the world.
The short supply of hard disks means less numbers of the PCs will be produced in the next several quarters until the floods recede and destroyed equipment is replaced. With less PCs, the demand for memory chips are going to be down as well.
Not knowing the full details, the market has done what it always does:? sell off the stock to the extreme.
These companies have solid balance sheets and can easily ride out the next few quarters of slow demand. But the stocks are quite cheap now and attractive investments. As the PC capacity comes back online, demand for these chips are going to ramp up rapidly and these stocks should perform well.
Bottom-line: Don’t Put Yourself in a Bucket. Invest Where the Opportunities Are.
You may consider yourself a value investor or a growth investor, but in real life, the good investment opportunities do not always come neatly labeled as value or growth.
If you stay aware to the different possibilities, you are more likely to find great investments that fit your investment criteria and objectives.
Ultimately, remember, if you do not believe you are getting a good value for the price you paid for your stock, you are not investing, just speculating.
About the Author: Shailesh Kumar, MBA writes about value investing at Value Stock Guide where he runs a popular value oriented stock picking service!