Investors sometimes carry stereotypes in their heads about the characteristics of value stocks as opposed to growth stocks. The value investor smugly imagines that the true investor only looks at a certain type of company and shuns those dynamic, thrusting go-ahead enterprises that are favored by investors looking for growth companies. This type of value investor may imagine that a value investment must be in a mature but rather unadventurous company that sticks to its core business and never steps outside the confines of its narrow mission statement. This value investor will patiently look for such a staid, solid company and move in to invest as soon as its share price decreases well below its real value. After all, if this solid company just survives and keeps plodding on along its well-trodden profitable pathway its temporarily depressed share price will increase and earn a return for the value investor.
Of course the above value investor will certainly earn a good return on investments and is likely to be a very successful investor. But this limited view of value investing means that a lot of further opportunities will be missed. A good value investment is not restricted to shares in companies associated with any particular corporate culture, industrial sector or business strategy, provided that the investment conforms to the established aims and principles of value investing.
The value investor is typically looking to invest in the long term in an industry leader in a well understood industry. The earnings per share should be above the current average for the industry, the price earnings ratio will be lower and the company will normally be returning cash to shareholders in the form of high dividends.
The typical growth stock on the other hand may offend against some of these principles in the eyes of the value investor. The growth enterprise is growing its earnings at a faster rate than the average, is in an industry that is expanding and may even be regarded as glamorous. The stock is performing better than the earnings estimates but may not be paying dividends. The typical investor may want to make the investment while the company is growing and then consider exiting when the period of fast growth comes to an end.
At first sight one may agree with the staid value investor that these two types of company are totally different and that one can be either a value investor or a growth investor but not both. However growth and value stocks are not opposites and there is no reason why a growth stock could not be a good opportunity for a value investor. A company within a growing industry may have undervalued stock. The management may be pursuing a sound strategy of growth that is well planned and keeps in mind the need to retain shareholder value. There is no reason why a value investor should not invest in such a company for the long term.
However the value investor may have some reason to be skeptical about the date when dividends will be paid out in respect of the growth stock. The White Queen promised Alice jam every other day, clarifying that the rule was jam tomorrow or jam yesterday but never jam today. The value investor may be inclined to side with Alice and question the value of such a promise. The future benefits depend on the accuracy of the growth predictions and these predictions need to be based on good evidence over and above past performance.
A growth investment may indeed be out of limits for a particular value investor. For example, a growth stock in a high technology industry may be rejected by a value investor as being outside the circle of competence of that particular investor. The investor may not have a good enough understanding of the industry to be in a position to assess the future prospects of the company or the industry. It may be impossible for this investor to assess the prospects of the company in terms of its competitive advantage over other companies in that industry.
The value investor is someone who has a well-defined circle of competence and does not move out of that circle however tempting an investment may look in an unfamiliar industry. However there is no reason why a growth stock may not be available inside that circle of competence. Not all growth stocks are in glamorous industrial sectors.
There are always possibilities for a value investor to find good growth stocks in an industry that the investor understands. These stocks can be analyzed using the traditional tools of the value investor and a decision to buy can be made on the basis of a rational assessment of the stocks regardless of any label they could be given as growth stocks. In every case the investor should proceed to analyze the fundamentals of the enterprise as for any potential investment.