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| Value investors are bargain hunters who search for companies they believe are undervalued — companies whose stock is trading at low prices that don’t reflect the true value of their assets or earnings ability.
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Professional stock investors tend to belong to one of two distinctly different camps — growth or value.
"Growth" and "value" are basic styles of investing. They both seek to invest in stocks that will appreciate in price, but they go about it in different ways.
Investing for growth
Growth investors search for companies whose revenues and earnings are growing rapidly, generally at an annual pace of 15 percent or more. Many investors are willing to pay high prices to participate in the potential for continued strong appreciation. However, due to the high expectations for performance, growth stocks may be punished harshly by investors if their companies fail, by even a few cents, to meet earnings projections. Sharp declines in the prices of Internet-related stocks are a good example of this.
Growth stocks typically have an above-average price-earnings ratio, or P/E. The P/E is the company's current stock price divided by its earnings per share. For example, if a stock is trading at $40 and earnings for the last fiscal year were $2 a share, the stock would have a P/E of 20.
A high P/E usually means investors are enthusiastic about a company's prospects and are willing to pay a premium for it. Growth stocks usually have P/Es of 25 or higher, which reflect those lofty expectations.
P/E ratios can vary significantly over time, but the average P/E ratio for the stock market as a whole is generally around 15. It can be as low as 6 during a depression and zoom above 20 during an economic expansion.
Investing for value
At the other end of the spectrum, value investors are bargain hunters who search for companies they believe are undervalued — companies whose stock is trading at low prices that don't reflect the true value of their assets or earnings ability. Often, these companies are disdained or overlooked by other investment pros, which tends to lower their share prices. Or the stock price may be temporarily depressed due to corporate restructuring, management changes or a short-term setback.
Value investors seek stocks with low P/Es — a sign that other investors don't have much faith in the company. Value managers also focus on companies with solid fundamentals in established industries.
Value stocks offer several advantages. For instance, they're affordable; also, since the stock is already selling at a discount, a disappointing quarter may not cause it to decline as steeply as a growth stock would. However, there is always the risk that the price of a value stock will not recover.
Generally, growth stocks perform better during bull markets, while value stocks tend to do better
in bear markets. Investors can never be certain when one investment style
will outperform the other, or, just as important, which will be less volatile.
Since growth and value stocks perform differently during changing economic
conditions, a well-diversified portfolio may benefit from a combination
of both styles.
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