Investment styles and techniques - 2 - Veterinary Practice
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InFocus

Investment styles and techniques – 2

GORDON NICOLL
continues his series explaining
different types of investment
with a look at the distinctions
between ‘value’ and ‘growth’
investments and how the two
approaches can be combined

HAVING come up with the snappy title “Investment Styles and Techniques – 1” for my last article, I set out to provide some explanation of the terminology used to describe the various types of approach employed by fund managers. This time I have really tried to push the inspiration boat out with the title! As indicated previously, in this piece I will look at the distinctions between “value” and “growth” investment, how the two approaches are sometimes combined and the significance of a company’s ability to pay dividends.

How do value and growth investment differ?

These terms refer to the overarching strategies that a manager may adopt when choosing companies to invest in. Value investing is a strategy of selecting stocks that trade for less than their intrinsic value. Value investors actively seek companies that they consider the market has undervalued, believing that the market over-reacts to both good and bad news resulting in stock price movements that do not correspond with a company’s longterm fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated. The big problem for value investors is calculating the intrinsic value, as this assumption is very subjective. Although the current value of a company’s assets can be calculated, the wider value including future profitability is a matter of opinion, rather than fact. Two investors can be given the exact same information and place a different value on a company.

Margin of safety

For this reason, another concept central to value investing is that of “margin of safety”. This simply means that you buy at a sufficient discount to allow some room for error in your estimation of value. Despite the different methodologies, it all comes back to trying to buy something for less than it is worth. An alternative method, known as growth investing, is also favoured by some investors. The concept involves researching and investing in companies in the belief that their profits and share prices will beat the market over a long period. At its simplest level, the idea is to buy an acorn and then sit back and watch it grow into a giant oak. In recent years many astute investors have made sizeable sums from purchasing stock in fledgling companies and watching them grow into huge multi-national business empires.

Humble beginnings

Perhaps the best example of the ideal company for a growth investor is Microsoft. From humble beginnings in 1976, Bill Gates has grown his business empire into the world’s most successful computer company. Taking Microsoft as an example, from March 1986 the stock has grown by 25,005%. Or to put it another way, if you’d invested £5,000 in 1986 it would be worth a staggering £1,382,900 today (Source: Bloomberg. Data to 7th July 2011). However, once companies reach a certain size and capture the majority of the market share, their characteristics change. With little room left for growth but strong balance sheets gained through years of solid, consistent results, they begin to demonstrate different traits. Again, taking Microsoft as an example, it could be argued that it now behaves in a similar way to a utility stock: lower volatility and consistent dividend distributions. Growth investors, therefore, tend to invest more frequently, looking for companies that have the potential for good growth over the medium-term.

Do fund managers use both strategies at the same time?

Yes. Sometimes considered a hybrid of both growth and value investing, a Growth at a Reasonable Price (GARP) strategy looks for companies that have both good growth potential and are currently trading at an attractive price. A common misconception is that GARP investors hold a portfolio with equal amounts of both
value and growth stocks. However, GARP investors identify stocks on an individual basis, selecting those that demonstrate both characteristics.

Does a company’s ability to pay dividends matter?

Yes. Some fund managers employ a technique known as “income investing”. As the name suggests, this strategy focuses on the income from the underlying investments (in the form of dividends or interest payments) to enhance returns over the long term. Income investors generally focus on older, more established companies that tend not to be in rapidly expanding industries. These companies balance the need to reinvest their earnings back into the company to fund growth and expansion plans with paying out the earnings in dividends as a reward for loyal shareholders.

Utility companies

For this reason, dividends are more prominent in certain industries. Utility companies, for example, have historically paid good dividends. There are many companies with strong dividend records, one of the best examples being Johnson & Johnson, the
US pharmaceuticals firm. From 1963 to 2004, Johnson & Johnson increased its dividend every year. If an investor had purchased the stock in 1963, the dividend yield on the initial shares would have grown approximately 12% annually (Source: Bloomberg, July 2011).

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