24 Oct 2019

3 stock investing strategies: Growth vs. Value vs. Income

If you’re serious about investing, you will come across these terms: growth stocks, value stocks, and income stocks. These three refer to different investing strategies. But say you understand the three strategies. How then do you choose what’s suitable for you? We’ve compiled the information for you.

Growth investing: Picking companies with strong earnings growth prospects

Companies classified as “growth” would typically be:

Newer companies;
In younger industries (e.g. technology); and/or
In emerging markets.

Growth investors would be looking for capital appreciation, which they hope will occur when the companies they invest in grow revenue and earnings rapidly.

By investing in growth companies, you should be prepared to be invested over the medium term at least, to have better chances of seeing the companies’ business expansion programmes turn in higher profits.

The risk is that high-growth companies may spend too much on investment. So they may not have enough funds to sustain them while they’re waiting for their expansion programmes to generate cashflow and profits.

To spot your growth stock opportunities, understand these three factors.

Factors	How?
The growth prospects of the companies you follow	Growth in earnings per share (EPS): What are analysts saying about the company’s EPS prospects in coming years?
The competitive challenges they face in achieving growth	Returns on equity (ROE): Is the company delivering good returns to shareholders even as they are growing their businesses?
Whether they can achieve their expansion plans without running into cashflow problems	Cash flows: Does the company have positive cash flows? If not, their expansion plans might endanger their financial stability Current ratio: Are they able to meet their financial commitments as they come due?

Growth investing

Value investing: Picking companies that are trading significantly below what’s normally regarded as “fair value”

Like growth investing, value investing is also about capital gains. But these companies go about generating it differently. That’s because value investing is about spotting companies which are trading undeservedly at:

Relatively low price-to-earnings (P/E) ratios,
Below book value (P/B), or even
Below cash value.

The key word here is “undeservedly”. Markets are generally quite efficient at pricing stocks. So, you don’t usually get undervalued stocks for no reason.

Sometimes, stocks are cheap because they ran into financial difficulties since the last financial year-end. In such cases, the historical ratios may not be relevant any more.

As such, the challenge of a value investor is, how to determine whether the underlying business is still sound and whether the company can overcome the prevailing difficulties. It’s similar to determining whether an injury is fatal, or a flesh wound that will heal.

Investing in value stocks may require patience, as it sometimes takes many years for value to be restored. Often, a stock becomes undervalued because of transient difficulties which may pass over time.

To spot a genuine value stock opportunity, you need to understand:

Factors	How?
Whether these stocks are undervalued relative to similar stocks	In determining “value”, it is useful to compare the company’s P/E and P/B ratios to: Its industry peers; and Its own price history.
Whether their undervaluation is due to Some transient/passing problem; Temporary sentiment; or Something more fundamental and lasting.	Whether the underlying business has been damaged beyond repair Whether the company has the financial resources to ride out a rough patch. Look at their: Debt-to-equity ratio; Current ratio; and Whether the company has been generating positive cashflow

Value investing

Income investing: Picking stable companies with stable dividends

Key to income investing is picking companies that are generating stable earnings, pay a good amount of their earnings as dividends to their shareholders (good pay-out ratios), and have strong underlying assets or businesses. This sort of companies are typically mature companies.

Contrast this to growth stocks.

“Income” companies	“Value” companies
Typically mature companies	Typically younger businesses
Generating stable earnings	Using up a lot of earnings to expand the business; OR Generating less earnings
Higher payout ratio	Lower payout ratio

Income investment opportunities are often found in utilities (e.g. telecommunications companies, toll road owners, energy generators) and real estate investment trusts or REITs.

For income investing, you want to look for:

Factors	How?
Stability of earnings	Consistent growth in EPS
Pay a good amount of their earnings as dividends to their shareholders	A stable and high pay-out ratio
Earns you more than the risk-free rate	Calculate the dividend yield (or distribution yield for REITs) over a risk-free asset such as the 10-year Singapore Government Security yield

Income investing

So... Which style/strategy should I use?

The choice often comes down to personal risk appetite and preferences. We summarise the pros and cons for you in this table:

Stock investing strategy	Pros	Cons
Value investing	Bigger gains than income or growth investing, because the company has fallen significantly below the valuations of comparable companies During times of financial crisis. When the crisis passes, valuation is quickly normalised, often offering unusually large gains	Involve considerable risk Need enough patience to wait out the situations that caused undervaluation
Growth investing	Generally, where a company has a good business and sensible expansion plan, growth companies tend not to be as risky as undervalued stocks	Expanding too much, too fast, resulting in financial difficulties and sometimes even insolvency
Income investing	Usually in mature companies with proven earnings-generating businesses, which pay out reasonably stable dividends.	Generally have much less potential for capital gains than growth or value stocks

So what’s an investor to do? Consider a diversified approach, where you grow your stock portfolio with a mix of growth, value and income stocks.

In other words, don’t put all your eggs in one investment style. And as you diversify, it may be useful to look overseas for investment opportunities, in markets such as the US, Europe, Japan, and Hong Kong.