Growth Investing vs Value Investing - Which is Best for You?

Anyone who is serious about investing in stocks, would be at least aware of value investing.

Investors, young and old, new and experienced, have adopted it all over the world. Many swear by it and apply its principles in every investment. Others use it only to an extent.

Some are aware of the concept and would like to know more. These investors should learn the basics to value investing.

Whatever their level of knowledge about the topic, most investors will agree that it's the foundation of all investing strategies.

Warren Buffett, the most successful investor in the world has said, 'All investing is value investing'.

And it's hard to argue with that.

After all, the purpose of value investing is to find out what a company is worth and then buy it at a discount. This was pioneered by the father of value investing himself, Benjamin Graham. What could be better than this strategy?

Well, things are not as cut and dried in the world of investing.

In this article we will examine value investing's cousin. We will try to understand why many investors prefer it and if you should make the switch.

So let's jump into the exciting world of 'growth investing'.

What is Growth Investing?

First things first. You should know what growth investing is not.

It's not about preservation of capital. It's not about keeping your money somewhere safe. It's not about keeping up with inflation. It's not about earning a regular income from investing.

Growth investing is all about one thing only, i.e. increasing the value of your investment portfolio, preferably at a fast rate.

That's it. It's the only thing all growth investors want. As long as their investments are gaining in value, growth investors are happy.

If their investments fall in value, most growth investors, with some exceptions, will consider selling. They may even use stop losses to ensure they don't suffer a big loss.

To a growth investor, if a stock isn't going up, it's not worth investing in. It's as simple as that.

This is contrary to the thinking of value investors who want stocks to fall so that they can buy them.

So what explains this difference?

Difference Between Growth and Value Investing

The fundamental difference between growth investing and value investing is in the decision to buy and sell a stock.

Value investors buy low and sell high.

Growth investors buy high and sell higher.

Value investors desire a margin of safety in all their investments. This is a central concept in value investing. They want to buy at a discount to the intrinsic value of a stock.

The desire for a margin of safety is the reason why they wait for a stock to fall before buying it. A correction brings the stock's price down to a cheap valuation. Thus, they buy low.

They then wait for the market to take the value stocks back up to a fair or expensive valuation. Thus, they sell high.

This is a proven, time-tested, market beating investing strategy. It's used all over the world by many successful investors.

But value investing has its drawbacks.

• It demands emotional stability during volatile market conditions.
• It insists on a margin of safety before investing. In its absence, investors should not buy stocks.
• It requires buying stocks only at cheap valuations, often at a low price to earnings ratio and at a price to book value below one.

If these conditions are absent, especially during a bull market, then value investors will not find many investments. They may have to sit on cash.

On the other hand, growth investors care only for...growth. They're always on the lookout for stocks with significant potential to go up in price.

Concepts like margin of safety are not of much importance to them. They're mostly interested in knowing the reasons why a stock will appreciate.

The buy and sell decision usually comes down to earnings growth.

Growth investors believe that if a company can grow it's earnings, i.e. net profit and earnings per share (EPS) at a high rate, then it merits investment.

They usually consider the following points before investing.

• The rate of EPS growth (quarterly and annually).
• The rate of sales growth.
• The company's growth relative to its industry and the rest of the market.
• The company's historical and more importantly, future growth outlook.
• The size of the company. Smaller companies tend to grow faster than larger ones.
• The chances of an increase in the profit margin. Can the profits grow faster than sales?
• Return on capital. If it's below the cost of capital, then growth actually destroys value instead of creating it.

Clearly the two investing strategies are like night and day. This is why most investors tend to prefer one over the other. They find it difficult to implement both at the same time.

Which Strategy is Better?

Well there is no straightforward answer to this question. Investors tend to prefer one over the other based on their own investing temperament.

For example, do you like the idea of buying stocks after a correction only to sell them when they bounce back? If so, then you may be suited to value investing.

Or do you like to study companies to find out how much they can grow? In that case, you may like the idea of growth investing.

Of course it is possible to do both but that would be too much for most investors.

Why has Growth Investing Become so Popular?

Ever since the global financial crisis of 2008, there has been a big development in stock markets.

Value investing lost its appeal and growth investing became the dominant investing strategy. This is because top growth stocks have done much better than steady dividend paying stocks.

From individual investors to fund manager, they have all adopted growth investing. Most people when they invest in a mutual fund today, are choosing a growth strategy.

Why is that the case? Why has growth investing become so popular?

The Fuel Driving the Growth Stock Fire

The biggest reason for the dominance of growth investing has been low interest rates (between 2008 and 2021) around the world.

Now you may wonder what interest rates have to do growth investing. Well, quite a lot as it turns out.

You see, the value of any company depends how much money it can make over time. If a company can generate a lot of profits and cash flows over the long term, then it's only a matter of time before it gets noticed by the market.

However, to calculate the value of a company today, an analyst needs to find value today of all the cash the company will earn in the future. This calculation is called discounted cash flow (DCF).

And this is where interest rates come in.

The 'discounting' is done by using the 'risk free' interest rate. This is usually the 10-year government bond yield.

Whenever the central bank of a country raises interest rates, the 'safe' government bond yield also goes up and vice versa. Thus investors have a higher incentive to keep their money in bonds instead of stocks.

Also, the future cash flows will now have to be discounted at a higher rate. This lowers the value of the cash flow today.

This is bad for companies that will generate most of their cash flow in the future. In other words, it's bad for growth stocks.

Now consider the opposite scenario. What if interest rates remained low for a long time?

In this case, government bond yields (the discounting rate) will remain low for a long time. And so, future cash flows will be more valuable today.

Well, this is exactly what happened in most of the developed world since 2008. Interest rates were low for a long time. This gave high growth stocks a long runway. Investors kept buying more and prices kept going up, which in turn brought in more investors...and so on.

Before You Switch to Growth Investing...

If you're not a growth investor, then before taking the plunge, think carefully about this decision.

Why do you want to be a growth investor? Are the returns you're earning too low?

For example, what are your returns from value investing? You might discover that you're returns are good enough. You may not need to take on additional risk in your portfolio by buying growth stocks.

It's important to understand that growth stocks have a lot of investor expectations driving them higher. This is why they trade at high PE ratios. In fact, they are the most expensive stocks in the market.

If these expectations are dashed due to poor quarterly results or some unexpected event, then growth stocks will crash.

Then there is the industry aspect to consider. Value investing doesn't always demand good industry knowledge. But growth investing does.

Are you willing to put in the extra time and effort to understand how the industry works? If not then growth investing is not for you.

Finally, watch out for higher interest rates.

Interest rates are going up all over the world. This will put the breaks on growth stocks. We have already seen this play out in the massive sell-off in US tech stocks.

In the domestic market, Indian IT stocks have taken a hit partly due to the relentless fall in the Nasdaq.

New-age IPOs were the darlings of Dalal Street at the start of 2022. They have been taken to the cleaners. These were the worst kind of growth stocks, ones without any current or even future profits. A good example is Zomato which is still not profitable.

These are all very real risks you will face when you switch from value investing to growth investing.

To be clear, we are not discouraging a move like this. If you think you have the temperament to b a growth investor, then go ahead. Just keep all the risks in mind.

To make such a transition smoother, here are a few pointers. We believe these will be helpful to new growth investors.

• Start with high quality stocks. Read annual reports. Look for fundamentally strong stocks no matter how fast or slow their growth rates.
• Look for growth over the long term. Check the last 7-10 years financials. This will weed out any companies with short term growth spurts.
• Avoid companies that fund their growth with a lot of debt. Insist on a debt to equity ratio below 1. The lower the better.
• Don't invest in any loss making company or turnaround companies in India.
• Make an attempt to understand the industry dynamics. If the industry is too complex for you, don't invest in those stocks.
• Don't overpay for growth. Don't buy stocks at 60 or 80 PE. Put an upper limit for the PE ratio with which you are comfortable. Ideally, a PE not more than 30 or 40.

We hope this article has opened your mind to the idea of growth investing, its pros and cons.

If you would like to become a growth investor, check out Equitymaster's screener on the top growth stocks in India.