The three main investment styles: income, value, and growth
Investing can seem complicated, but, in fact, it all boils down to three simple approaches. Phil Oakley explains what they are and how you can use them to build your portfolio.
I love reading about “investment gurus”.
It's fascinating to find out more about the lives and investment methods of people like emerging markets pioneer Sir John Templeton, or legendary US investor Warren Buffett. It also inspires you to get up off your backside and take charge of your own investing.
However, it's also easy to get confused. Whose advice should you follow? Which approach is best for you? Are there some styles that just don't work anymore?
The good news is, for all the individual flourishes and exciting deals made by gurus', there are only really three basic approaches to share investing.
As we've discussed, you can make money out of stocks in two ways: through dividend income and through capital gains.
Depending on how heavily the focus falls on one or the other, you're approach will likely fall into one of these three broad categories: income investing, value investing, or growth investing.
We'll look at each in turn below.
The “buy and hold forever” approach
Income investing, which is what we've focused on in the last two emails, is the closest thing to a pure buy and hold forever' strategy you can get. Indeed, MoneyWeek's income expert, Stephen Bland, recommends doing precisely that.
With income investing, the dividend payment is what matters. Movements in the share price are secondary. So the key is to find companies paying high, sustainable dividend yields.
As we noted last time, sustainable' is the key word here. There's no point in buying a stock for its high yield, if the dividend then gets cut. We'll look at other ways to testing dividends in future emails.
You then buy enough of these stocks, across enough different sectors, so that a disaster for one or two stocks or sectors doesn't destroy your portfolio. After that, you can just sit on the portfolio and take very little action.
It's worth remembering that while capital growth isn't the priority here, companies that manage to pay high, sustainable dividend yields are likely to see their share price rise too. That's because you can't pay a solid dividend for long without enough cash coming in the door to pay for it.
This is why we think dividends are so important: they are among the few indicators of a company's health that are very hard to fake.
The contrarian approach
Value investing is often seen as quite a staid and sensible method of investing. That's perhaps because of its association with folksy US investment legend Warren Buffett, who always presents himself as being the direct opposite of the hotheads on Wall Street.
We'd agree that value investing is sensible, but it's anything but staid. If you want to find genuine value, then you're going to have to buy stocks that everyone else in the market hates.
Value investing is basically just another word for contrarian investing. To be a successful value investor, you have to be confident that you know something that the rest of the market doesn't.
In fact, the whole notion that value investing' is even possible, challenges an entire body of academic financial theory. The efficient market hypothesis' states that markets rationally take into account all information known about a stock at any given time. Therefore, the price of a stock is always the right' price.
Clearly this is nonsense, for reasons we've discussed before. But it's nonsense that is widely believed. So the idea that value investors can find stocks that the market has mispriced' is a pretty contrarian notion in itself.
The father of value investing, Benjamin Graham, characterised the market as being prone to volatile mood swings. One day Mr Market is cheerful and optimistic the future holds nothing but good news, so he'll buy your stocks at any price.
The next day, he's miserable. Nothing will ever go right again. He'll sell his stocks to you at any price just to get them off his hands.
The trick for value investors is to take advantage of these mood swings. They find stocks that have been unduly' punished, and seen their share prices plunge. They wait until the market realises its mistake and the share price recovers. And then they sell them.
This process can take some time. But while value investing is often a buy and hold for a while' strategy, it's not buy and hold forever'. If you want to make money from value investing, you have to take your profits when a stock no longer represents good value.
And it's not as easy as it sounds. Everyone thinks they can beat the market. Everyone thinks they're a contrarian.
But successful value investors have to dig deep and have a very strong grasp of how to analyse a company's fundamentals'. That is, they need to know how to go through its accounts with a fine-tooth comb and calculate the stock's fair' value.
Graham also talked about the importance of having a margin of safety'. In other words, you want to buy the stock when it's trading well below its fair value, so that your downside is limited.
In short, this is a far more active strategy than income investing, but it can potentially be extremely profitable, not to mention satisfying. We'll be looking at value investing and how to analyse a set of corporate accounts in a lot more detail.
The hunt for the ten-bagger
Growth investing, as the name suggests, focuses more on capital gains than income. With this strategy, investors hope to find companies that can grow their profits rapidly. If this happens, they reason that the share price of the company will go up rapidly as well and they will make a lot of money.
You won't find growth companies paying big dividends to shareholders. All the company's profits and cash flows tend to be reinvested back into the business so that it can grow.
These companies are often small stocks. And it's not uncommon for them to be making losses. For example, a company may need to invest in new factories and equipment to make its products. Or it may be spending a lot of money researching and developing its next winner before it makes any sales.
This means that you won't find these kind of companies in the bargain basement of the stock market. Their shares will look expensive relative to their profits or assets. Value or income investors tend to steer clear of these types of stock.
You can do extremely well buying growth companies.Investors such as the American Peter Lynch made lots of money this way.
However, you have to do your homework. This goes for all styles of investing, but it's doubly important when buying growth stocks. Back the wrong company or pay too high a price, and you often have little to fall back on whilst facing the prospect of big losses.
So when looking at a growth stock, you have to have a lot of confidence in a company's products and business model. You have to believe that it will be able to sell its products to lots of customers, without lots of competition.
The classic example of this advice being ignored was the dotcom boom at the end of the 1990s. People thought the internet would see rapid growth which turned out to be true but they ignored the fact that it allowed competition to flourish as well.
Some companies that floated on the stock exchange at very high valuations became worthless very quickly as their business models and products were exposed to competition.
Another example is the airline industry. The business has grown rapidly more people are flying than ever before but this rapid growth in air travel has not made investors in airlines rich. The airline industry has made a cumulative loss since it began, because there is too much competition.
The other thing to bear in mind is the price you pay for growth stocks. There are certain large successful companies, such as Coca-Cola, Walmart or Procter & Gamble that would generally fall into the growth' category rather than income' or value'.
That's because these companies are so highly prized that they rarely, if ever, become cheap' in investment terms. Yet their consistent ability to grow profits has still seen long-term investors do well.
But these companies are not a buy at any price. Overpaying for growth because they get sucked in by hype - is a common mistake that investors make and a major reason for losing money.
So while you won't find these stocks in the bargain basement, you are looking to pay reasonable prices, not silly ones. We'll look at various financial ratios that can help you to do this later in the series too.