This article is part of Morningstar.co.uk's Equity Investing Week.
Capital vs Income
Some stocks provide the investor with capital, i.e. it increases in value such that the shareholder can sell at a future date and lock in a capital gain. Other stocks provide the investor with income, i.e. the stock may not increase radically in value but the company pays out regular dividends that create a steady income for the shareholder.
Those seeking capital will often hunt out start-ups, small-caps, or companies that are misunderstood or under-researched. Those in need of income tend to be better off focusing on well-established businesses that have completed their growth phase and moved on to rewarding shareholders with dividends and buy-backs.
Value vs Growth
Similarly, some equity fund investors seek out value, i.e. stocks that they deem to be worth significantly more than the market currently values them at, while others go in search of growth opportunities in the form of stocks that show substantial potential for price appreciation on the back of earnings.
Thus, equities have numerous potential roles to play in an investor’s portfolio. Yet the capital versus income characteristics of stock investing tends to be more widely understood compared to the growth versus value aspects.
Let’s dig a little deeper into the latter.
Value Investing
Everyone has a different definition of value. For example, you and your best friend are comparing footwear. You call your shoes a deal because you got them on sale—50% off! Your friend, meanwhile, considers her shoes a value buy simply because she paid less than she would have for a comparable brand.
Fund managers who buy value stocks express similar differences of opinion. All value managers buy stocks that they believe are worth significantly more than the current share price, but they tend to argue about just what makes a stock a good deal. How a manager defines value will determine what his or her portfolio includes and, ultimately, how the fund performs.
Relative Value
Fund managers practicing relative-value strategies compare a stock's price ratios (such as price/earnings, price/book or price/sales) with a benchmark and then make a decision about the firm's prospects. In other words, value is relative. These benchmarks can include one or more of the following: the stock's historical price ratios; the company's industry or subsector; the market.
Absolute Value
These managers don't compare a stock's price ratios with something else. Rather, they try to figure out what a company is worth in absolute terms, and they want to pay less than that figure for the stock.
Absolute-value managers determine a company's worth using a variety of factors, including the company's assets, balance sheet and likely future earnings or cash flows. They may also study what private buyers have paid for similar companies.
When Value Managers Sell
There are two chief reasons value managers will sell a stock: It stops being a value, or they realise that they made a bad stock pick.
Stocks stop being good value when they become what managers call fairly valued. That means that the stock is no longer cheap by whatever value measure the manager uses. For relative-value managers, that could mean that the stock has gained so much that its price ratios are now in line with industry norms. For an absolute-value manager, that could mean that the stock's price now reflects the absolute worth the manager has placed on the company.
A manager may also sell a stock because it looks less promising than it did initially. In particular, new developments may lead the manager to a less favourable evaluation of the company. Nevertheless, if the stock's price drops but the manager believes the company itself is still attractive, that may be a chance to buy even more of it.
Growth Investing
Not everyone loves a sale. After all, sales can be messy and tiring and you can pick up some real duds along the way.
Value and growth are often considered opposites in investing, and for good reason. Most growth managers are more interested in a company's earnings or revenues and a stock's potential for price appreciation than they are in finding a bargain. Thus, growth funds will usually have much higher average price/earnings and price/book ratios than value funds, as the managers are willing to pay more for a company's future prospects.
Earnings-driven Growth
The majority of growth managers are earnings-driven, which means they use a company's earnings as their yardstick for growth. If a company isn't growing significantly faster than the market average or its industry peers, these managers aren't interested.
Within this earnings-driven bunch, momentum managers are by far the most daring. Momentum investors buy a rapidly growing company that they believe will deliver a quarterly earnings surprise or other favourable news that will drive the stock's price higher. Momentum managers pay little heed to stock prices. Their funds, therefore, can feature ultra-high price multiples. And high portfolio turnover.
Some managers seek earnings growth in a different way. Instead of searching for stocks with the potential to surprise during earnings season, these managers seek stocks that boast high annual growth rates: generally between 15% and 25%.
The most moderate earnings-growth-oriented managers look for stocks growing in a slow but steady fashion. As long as these stocks continue to post decent earnings, slow-and-steady managers tend to hold on to them. Steady-growth funds often have more modest price ratios than their peers.
Revenue-driven
Of course, not all growth companies have earnings. In particular, younger companies may be unprofitable for years until their businesses reach critical mass. Some growth managers will buy companies without earnings if the companies generate strong revenues. (Revenues are simply a company's sales; earnings are profits after costs are covered.) Because there is no guarantee that firms without earnings will ever turn a profit, this approach can be risky.
Growth at a reasonable price
Managers who seek growth at a reasonable price (GARP) try to strike a balance between strong earnings and good value. Some managers in this group find moderately priced growth stocks by buying the rejects of momentum investors. They also look for companies that have been ignored or overlooked by market analysts and that are therefore still selling cheaply. Like value investors, GARP investors try to find companies that are only temporarily down and out and that have some sort of catalyst for growth in the works.
Mixing it up
Few managers stick to just one kind of growth strategy. Instead, most blend a variety of stock-picking approaches—perhaps buying companies that grow slowly and reliably as well as faster-paced momentum names. Thanks to this diversity, these funds can perform better than their narrower peers across a wider variety of market environments.
