Growth or Value? Why not a blend of both?

By Financially Fit Staff

Investors often find themselves lodged between two schools of thought. 

The first is that growth stocks, while priced at a premium, are the better long-term investment due to their superior growth rates and rapid expansion. 

The second is that value stocks represent true bargains, and that by purchasing stocks that are discounted well below a fair value, investors can generate outperforming returns. 

The funny thing is that the concepts aren't necessarily mutually exclusive.  Finding a stock that exhibits characteristics of both and converge somewhere in the happy medium can be a great way to unlocking outsized returns. 

Although definitions vary, shares in a company whose revenues and earnings are expected to grow at an above average rate relative to the market are considered to be growth stocks. Growth stocks usually do not pay dividends, as these companies prefer to reinvest retained earnings in capital intensive growth projects. All growth stocks generally exhibit characteristics including high price-to-earnings, high price-to-book, and high price-to-sales ratios, and low dividend yields. 

Value stocks on the other hand, are considered to be bargains. The market has under valued the stock for a variety of reasons and the value conscious investor hopes to get in before the market corrects the price in order to represent the true value.  If a stock is under priced based on the valuation metrics applied, it is a good buy whereas if it is over priced, it is a good sell. Value stocks tend to exhibit the following qualities including a low price earnings (P/E) ratio, low price to book ratio, a price to earning growth ratio (PEG) less than 1, and high dividend yields. 

Although there a few exceptions, one area that won't generally intersect is dividends, as growth companies rarely pay dividends, feeling that shareholders can see a better return on money invested internally than money paid out to shareholders in the form of dividends.  However there are stocks that strongly exhibit the remaining characteristics of both schools of investing.  For example, there are stocks with superlative growth ahead of them that, relative to their peers, have low P/Es, low PEG ratios, and low Price to Sale ratios.  In a nutshell, they look undervalued relative to their peers, yet their financials look more like growth companies. 

Consider the following example.  Is firm A with a P/E of 5X earnings a better value than firm B with a P/E of 20X earnings?  Not necessarily because a key concept underlying every form of valuation, is the assumption that value is derived "relative to its peers."   If firm A's peers trade at 3X earnings versus its price of 5X earnings, then it could be overvalued.  Whereas, firm B which operates in a high growth industry, could be undervalued at 20X earnings if its peer group trades at 25X earnings.  Further, firm B could have a PEG ratio, which accounts for growth, of less than 1, a low Price to Sales versus its peers, or looks undervalued based on countless other valuation metrics. 

So, it's quite possible to uncover companies that are growth stocks in terms of their earnings growth outpacing the market and also exhibit many of the same qualities of value stocks.  We find these firms often tend to be the true gems, the ones with true stock appreciation potential.

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


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