Growth Stocks vs. Value Stocks

If you watch any of the financial channels or read any of the popular books in the investing section of Barnes & Noble, you're bound to come across two terms on a fairly regular basis.

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Growth stocks

and...

Value stocks

You'll hear various self-proclaimed investment gurus claim they're exclusively "growth investors" or "value investors."

They'll proclaim that a certain stock is a growth stock, while another is exclusively a value stock.

Once again, don't let the Wall Street jargon confuse you.

Let's try to grasp exactly what these two concepts mean...

What's a Growth Stock?

A stock with consistently above average earnings relative to the market as a whole, or its specific industry, is generally labeled a "growth stock."

Most growth stocks are associated with companies still in the early stages of their respective life cycles.

For instance, from its IPO in 1986 until the peak of the tech bubble in 2000, Microsoft (MSFT) was considered a "growth stock."

The company retained all of its earnings... Business as usual meant double digit growth in sales, customers, and margins... And growth in the PC software market and the company's earnings grew well above average relative to the rest of the market.

Because of these attributes, market experts tagged Microsoft (MSFT) with the "growth stock" label.

They also tagged small, fast-growing companies and companies in other fast-growing industries with the same "growth stock" label.

All right, so what's a value stock?

What's a Value Stock?

Well, according to the same experts, a value stock is a stock which trades at a lower than expected price relative to its business fundamentals.

Generally, stocks with low P/E ratios or high dividend yields are lumped together and classified by the experts as "value stocks."

Rarely do you hear a self-proclaimed investment guru label the same stock both a growth stock and a value stock.

Well, so what?

Should You Buy Growth Stocks or Value Stocks?

With all the stock market chatter that divides potential investments into "growth" and "value" categories, you have to ask yourself the question:

Should I buy growth stocks or value stocks?

This is a reasonable question, and I'll answer it with another one...

Why does a stock have to be one or the other?

Is it because some expert on TV says so?

To frame an argument as growth stocks vs. value stocks automatically assumes a stock is one or the other. Why can't a "growth stock" with fast-growing earnings also be undervalued like a "value stock"?

And if a fast-growing "growth stock" isn't undervalued, then isn't it by definition overvalued?

If so, who would want to buy something that's overvalued?

These questions expose the fallacy underlying the "growth stock" and "value stock" labels.

Instead of getting caught up in buzz words, forget all the noise you hear on the financial networks, in the money magazines, and in the stock investing section of Barnes & Noble.

Instead, focus like a laser on those companies which are growing and undervalued.

These companies are otherwise known as great companies at great prices...

Why "Hot" Stocks Provide Bad Investment Returns

Whatever you do, don't let the stock market buzz distract you.

No investment system out there can beat a great company at a great price.

Far too often, investors get caught up in the latest "hot stock" or "hot sector," and they get seduced into parting with their hard-earned money.

Don't let this happen to you!

Although some of these "hot stocks" turn out to be great companies, more often than not, these great companies are trading at very bad prices.

Remember, a great company doesn't justify any price. The Coca-Cola Company (KO) is a great company, but it's not worth 100 trillion dollars.

Maybe in the year 2050, it will be. But here in our day, it just isn't.

So don't fall for the myth which says you have to "pay a premium for growth."

Wharton professor Jeremy Siegel calls this "the growth trap." In his book, The Future for Investors, he lays out a pretty good case for why investors get burned by these "sexy" stocks.

Remember, purchasing a stock isn't a good investment because its earnings are growing fast or even because its stock price is growing fast.

Don't follow?

Ask yourself...

What is investing?

It's laying out money now in order to get more money in the future.

If that's your goal, then you need to look at every potential investment from every possible angle before jumping in, because the answer isn't always clear.

If it was, then a lot more people would be successful investors...

This is the problem with the whole growth stocks vs. value stocks argument.

Are you really sure your investment is one or the other? Maybe it's both.

But a lot of bright and successful people can't tell.

Look at their investment track record.

Why do they find it so difficult to choose the right investments?

There is a reason.

You learned it in "What's a Common Stock?"

Here it is...

95% of investors view stocks as stocks and businesses as businesses.

They should view stocks as partial ownership interests in a real business enterprises.

If the 95% operated from this business-like investment viewpoint, they'd find it a lot easier to pick the winners and the losers.

Need an example?

I'll give you one...

Business-Like Investing vs. Stock Market Investing

Since 95% of investors view stocks as stocks and not partial ownership interests in a real business enterprises, they always focus on the wrong things.

They focus on the stock, instead of the business.

They focus only on homerun investments, when if they focused on making good contact, they'd have a much better batting average and a few homeruns as well...

This point is illustrated by the following story...

In the summer of 2002, I got together with a family friend.

For the sake of argument, we?ll call him "Bob."

Bob is very intelligent and actually worked as an analyst on Wall Street. But he still fell prey to the stock market mentality, focusing on growth at any cost.

Bob recommended buying Cisco (CSCO) at $14 and asked if I had any stock recommendations.

"Sure," I said. "I like Anheuser-Busch."

At the time, Anheuser-Busch (BUD) was $50 per share.

What was Bob's response?

"Anheuser-Busch? How are they going to grow?"

This reaction was very telling.

While Bob thought his focus was on the company, it was really on the stock...

A little more than two years earlier, Cisco (CSCO) hit an all-time high of $77.31 per share. So I'm sure the reasoning went something like this...

Cisco is a great company, so when it returns to its all-time high of $77.31, my return will be almost six-fold.

Meanwhile, the line of reasoning for Anheuser-Busch (BUD) probably went something like this...

Beer isn't a hot growing market. Anheuser-Busch has been around for years. It's a $40 billion company. To double my money, it would have to become an $80 billion company. It'll take years to sell that much beer.

Now, I can only speculate on the details of Bob's reluctance to invest in Anheuser-Busch (BUD), but I do know that the slow-growth of beer sales was a factor. He told me so.

But what I can tell you how I arrived at my own analysis...

I looked at each company from a business perspective, and then I valued the business.

It's that simple.

So here's my analysis, still as fresh in my mind today as it was back then...

Cisco

Cisco (CSCO) derives most of its profits from Internet routers. While this is a fast-growing industry, where's the competitive advantage? Do consumers care who makes their router? If Cisco weren?t one of the best performing stocks of the 1990's, would the average Joe even know who they are?

If the end user doesn't know who they are, where's the pricing power? If you don't have pricing power, you're a commodity business...

Sure, Cisco has tons of cash. I'd like to get my hands on it, but they don't pay a dividend. Exactly what are they doing with all that cash? It would be nice if they would use it to launch a "Cisco Inside" media campaign similar to Intel's... then consumers would demand Cisco products. Are they really making decisions in the best interests of shareholders?

All right, what's the value of this commodity business moving forward? Despite losing more than 81% of its value in less than three years, it's still priced for above average growth? How will Cisco achieve that growth if it loses market share, and it's forced to compete on price...

Let's run the numbers.

Cisco (CSCO) might be a good investment, but I'm not sold. So I'll pass...

Anheuser-Busch

Anheuser-Busch (BUD) makes several of the most recognized brand name consumer products in the world. They dominate the beer market with over 50% market share. That market share has stood the test of time, and names like Bud, Bud Light, and other brands make me believe they'll continue to do so well into the future.

Beer volume in the United States is slow-growing, but China, India, and other emerging markets will have lots of beer drinkers. There's still room to grow.

Meanwhile, increasing sales isn't the only way to grow earnings. BUD's free cash flow gives them the ability to repurchase shares in the open market. A high return on equity means management is effectively allocating the company's capital. Brand name pricing power gives the company the ability to raise prices faster than inflation, and improvements in the manufacturing and distribution process continue to lower expenses on an annual basis, so margins should increase and push profits higher in the years ahead.

Meanwhile, what's the current price? $50?

Let's run the numbers.

It's worth a lot more than that! And it pays a dividend?

I'd like to buy a BUD please... Not the beer, but the company!

Six Years Later...

So how did that line of reasoning work out?

Well, BUD stock fell into a trading range between $40-$46 per share, and it stayed there for over six years!

During that time, I told everyone I knew - buy Anheuser-Busch! Buy Anheuser-Busch!

And I wasn't alone.

In spring of 2004, Warren Buffett revealed his affinity for Anheuser-Busch as well, buying several million shares on behalf of Berkshire Hathaway.

And in late-2008, Belgium brewing giant InBev announced it liked Anheuser-Busch too.

In fact, InBev liked Anheuser-Busch so much they purchased the entire company, paying investors $70 for each share on November 18th.

What was Cisco's closing price on November 18th?

$16.45 per share.

So in six years, Cisco stock provided investors with a 17.50% return.

Not bad. In those same six years, the overall return for the S&P 500 was minus 13.13%...

But Anheuser-Busch stock provided investors with a 40% return, excluding dividends...

That's right. Over that same time period, Anheuser-Busch paid its investors over six dollars in dividends per share, while Cisco didn't pay its shareholders a single penny.

Think a business-like investing perspective is a worthwhile endeavor...?

Focus on the Business and Its Value

What else does this story teach us?

It teaches us this...

Don't miss out on the growth of the great business that's been a great business, because you're too busy looking for the business that might be a great business.

Don't focus on doubling your money in two years. Doing so requires a 36% annual rate of return.

While every once and a while, an individual investment might double your money in two years - it's just not going to happen for your entire portfolio year-after-year.

At 36% per year, a $100 portfolio morphs into $1,014,301.93 in just 30 years!

If this is your expectation, I have bad news?

It's not going to happen.

But I also have good news.

It doesn't have to.

Your portfolio can generate generational wealth if it simply beats the market average by a few points per year on average.

So how do you do that?

Focus only on buying great companies at great prices.

Yeah, I know.

You're getting tired of hearing this.

But it can't be emphasized enough. After all, this is the surefire path to stock market wealth.

And you want to achieve success in the stock market, right?

Great Prices

The previous example also included a phrase you probably noticed...

Let's run the numbers.

You probably read that phrase and asked yourself, "Run what numbers"?

The numbers that help you determine the value of the business.

Remember, your goal is to purchase great companies at great prices.

And how can you do that if you don't know the answer to this question?

What's a great price?

Believe it or not, 95% of investors never even ask this question!

It's one of the primary reasons their investment decisions never work out the way they hope.

95% of investors fail to achieve their investment objectives because they don?t know the following?

The price you pay determines your rate of return.

This is known in the investment community as the Basic Principle of Investor Return?

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