How to choose stocks on the stock exchange: companies of growth and companies of value

How to choose stocks on the stock exchange: companies of growth and companies of value

Choosing a winning strategy in the stock market is not easy. We are not talking about speculative play using technical analysis. A more adequate approach for most investors is to buy shares for a long-term period for a specific idea. Consider two popular approaches to stock picking and their options: betting on growth companies and value companies.

“Growth companies” or “growth stocks”?

At a basic level, growth stocks are those that are growing at a rate faster than the market average. These are not necessarily the shares of a young technology company that burst onto the stock exchange, it can also be the securities of the “old-timer” of the market – a giant international corporation, whose business has gone up sharply. Usually, these are enterprises with an exclusive advantage: a unique technology or product.
To begin with, let’s define what growth is meant: growth in the value of stocks or growth in business? In the classic definition, of course, we are talking about business growth. For example, about high rates of revenue growth. Specifically now, not in the past. If you are looking for stocks that have risen significantly in the past, then they are called momentum stocks. Remember that previous growth in no way means future growth.
What are the high revenue growth rates? In fact, this is a matter of taste, but often the demarcation line runs at 20% per year. However, there is an exception to this. Companies from cyclical industries (oil and gas, metallurgy, heavy industry) can sometimes show high rates of revenue growth due to, say, rising raw material prices. But these growth rates are not sustainable (that’s why they are cyclical). For example, Exxon Mobil’s revenues grew by 40% in 2017-2018, which does not make it a growth company, since before that (from 2013 to 2016) it fell by half against the background of falling oil prices. In 2019, Exxon’s revenue fell again, and the collapse of the hydrocarbon market in early 2020 is not worth mentioning.

So all the same: “growth stocks” or “growth companies”? On the one hand, since we are talking about business growth, it is more logical to say “growth company”. On the other hand, we still invest in stocks, and buying bonds of a growth company is not what is called growth investing. But we consider the term “growth companies” to be more correct, since it focuses precisely on the characteristics of the company, while the term “growth stocks” is often used in relation to those stocks that have appreciated well.

Shares (companies) value

Shares (companies) value

In this case, there is no longer any ambiguity with the terms. Unlike growth companies, stocks should be called value, and the phrase “value companies” is incorrect. The point is that the key idea behind value investing is buying stocks at a low price. So it’s right: “growth companies” but “value stocks”.
The concept of value investing is often contrasted with investing in growth companies. Since the fair value of growth stocks is entirely dependent on future growth rates, investors are oblivious to financial multiples such as price-to-earnings (P / E) ratios, especially since many growth companies do not yet generate profits at all.
Conversely, investors who invest in value stocks tend to buy stocks that trade at a discount on financial multiples. The fact that they are already priced at a discount, on the one hand, provides some protection, because even in the event of bad reporting, the stock will not fall as much as the growth stock. On the other hand, it gives hope that, with good results, the discount on multiples will decrease, and shares will grow stronger than the rest of the market. Even if the company’s business is only going at a level that meets expectations, investors will be able to count on a high dividend yield.

Why is value investing perhaps an even more popular concept than growth investing? There are three reasons for this:

  1. For a long time, value investing has been synonymous with the right or fundamentally sound approach to investing. It began with the book Security Analysis by Benjamin Graham and David Dodd, which was published in 1934. Well, in the 1970s and 1980s, Warren Buffett did a great ad for value investing.
  2. In the second half of the 1990s, the rise in technology stocks caused a drop in the popularity of value investing, but that changed in the first decade of the 21st century. The crash in tech stocks has only strengthened the status of value investing as the most “efficient”.
  3. The concept of value investing is somewhat easier to implement and more intuitive. To estimate the fair value of shares issued by a growth company, it is necessary to build a DCF (discounted cash flow) model, which assumes a high level of business understanding. On the other hand, many value stocks are valued based on target multiples (P / E, P / B, EV / EBITDA, EV / Sales), which are easy to find in open sources.
However, it’s not all that simple with value investing. Before buying “cheap” stocks, you need to familiarize yourself with the value trap concept. These are the stocks that are cheap all the time, but their discount on multiples is not decreasing, but even growing due to the continuing deterioration in business. These traps are easiest to find in the commodity sectors, the financial sector, and emerging markets.
Examples of value stocks in 2020: Almost all commodity companies and banks, air carriers.

Stock selection strategies: GARP and deep value

Both of these concepts are satellites of the previous ones, somewhat supplementing and rephrasing the classical approach.
GARP (growth at reasonable price) is an attempt to add value investing elements to growth investing. On the one hand, we buy stocks of companies with high growth rates, but on the other, we make sure that they are not overvalued. This idea began to gain popularity after the dotcom crash. However, to be honest, all growth investors believe that they are buying shares at an adequate price, so the name GARP is more of a marketing ploy to attract investors. Now a rare portfolio of a GARP investor does without shares of companies such as Facebook, Amazon, Salesforce, Visa, MasterCard.
The deep value concept is to buy shares of distressed companies. The ideal candidate for deep value is a company whose problems have gone so far that business restructuring cannot be done without. The drivers of growth in the value of deep value stocks are usually layoffs of employees, sale of assets (including real estate), change of the CEO, and credit restructuring. Deep value lovers are now buying shares in air carriers, cruise liner operators, and movie theater chains.

Whichever strategy for buying stocks you choose, remember that there is a significant amount of irrationality in the behavior of the markets. Mass investors often make mistakes; patterns that have shown themselves well on historical data suddenly stop working. Make decisions thoughtfully and slowly, relying on your competencies and not looking back at the information noise.