Everyone wants to make money in the stock markets but not everyone does. And only a few make enormous amounts of profits.
While luck can play a role in success in equity investing what is important to understand is that successful investing is a combination of art & science.
And both these perspectives get covered in what is popularly called as “style of investing.”
Building the portfolio – 3 vectors
There is no one style or approach that is infallible or ensures consistent success. When starting the groundwork of creating an investment portfolio, one needs to take into consideration three basic vectors – S, L & R (Safety, Liquidity & Returns)
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It is not only about how much risk can we take but also about how much risk we are willing to take (Risk appetite & risk tolerance)
What is the investment horizon and are there intermediate or regular cash flow needs.
The higher the expected return, more will we have to compromise on safety or liquidity or both.
Stock selection – The Investment style
After the above step, comes the process and criteria of stock selection and this is where the investment style comes.
Various investing styles can be used, including aggressive, defensive, balanced, cyclical and market capitalization-based like large cap, midcap and small cap.
Simply defined, the growth investing style involves investing in stocks that have an earnings growth that is substantially higher than the market average.
Growth stocks are aggressively valued by the market and thus they typically display higher P/E (price to earnings) & P/B (price to book) ratios and also better earnings per share (EPS).
At the same time dividend yields may be minimal because most of the profits are ploughed back into the business.
Growth stocks generally exhibit higher volatility, but they also benefit the most from strong macroeconomic conditions, which act as tailwinds for these stocks.
Investors mostly buy these companies with the intention of earning higher capital appreciation rather than dividends.
Value investing focuses on identifying mature, fundamentally strong companies but with beaten-down prices. Hence, value investing involves buying stocks, whose calculated intrinsic value is much higher than the current market price, offering a high potential upside.
Such companies may be undervalued for a variety of reasons. Some may have gone through a cyclical underperformance, some may have been ignored by the market due to unsatisfactory past financial performance and some may be turnaround cases due to factors like change of management, change of line of business, new product launches or new capital infusion.
Growth v/s Value Investing – which one to choose
In short, growth investing refers to investment in companies that are growing faster than the market, whereas value investing focuses on taking advantage of opportunities when fundamentally sound organisations are presently undervalued.
From time to time, when growth stock prices seem too costly, value stocks garner more attention. This is because value stocks often trade for less than their intrinsic value, which includes having lower P/E and P/B ratios than the industry average.
While overall firm fundamentals may remain robust, the stock market occasionally punishes fundamentally strong companies whose short-term business performance may have been unsatisfactory.
In the Indian stock markets, before the comeback in 2021, in three consecutive calendar years (2018, 2019, 2020), value investing underperformed while growth investment style gave handsome returns.
Following only one of these two styles can make a portfolio more volatile and have a negative effect on portfolio performance on a risk-adjusted basis.
No one particular investing style performs consistently over long periods of time. In addition to this, there could also be an extended cycle of underperformance for any one of these investment styles.
Therefore, a balanced portfolio that incorporates a combination of these 2 styles (aptly named “blend” style of investing) can be a better choice for investors to get a consistent portfolio performance.
(The author is CEO – Fisdom Private Wealth)