Sustainable growth potential combined with value give investors the best opportunity to earn higher and stable returns
By Malvika Saraf and Parthajit Kayal
A stock may remain undervalued or cheap for some time due to market inefficiency. Value investors like to buy this kind of stock as they believe these stocks will eventually be valued fairly. Growth stocks represent firms that have shown better-than-average gains in earnings in recent years and that are expected to continue delivering high levels of profit growth.
History shows growth stocks have the potential to perform better when interest rates are falling and company earnings are rising. Value stocks, often cyclical in nature, may do well initially in an economic recovery but are typically more likely to lag in a sustained bull market. When thinking about long term investment, some investors combine growth and value stocks for the potential of high returns with less risk. This approach allows investors to gain throughout economic cycles in which the general market conditions favour either the growth or value investment style, smoothening returns over time.
What is value investing?
Value investing is an investment strategy where the investor seeks profit from picking undervalued stocks, i.e., stocks that trade for less than their intrinsic value. The price of a stock depends on people’s expectations in the market. During bullish periods, people are willing to pay a higher price to own shares of the company whereas in bearish times they want to pay much less.
That is the reason value investors prefer to buy stocks during bearish times as their expectations are running low. Alternatively, during bullish times they are looking at good, neglected stocks, which other investors do not favour. A value investor would buy stocks when he believes that the price he is paying is much less than the fair value of the company’s shares.
Measures used for value investment
There are two stock specific valuation ratios popular for value investment— price-to-earnings ratio (P/E ratio) and price-to-book ratio (P/B ratio).The P/E ratio is the ratio of a company’s stock price to the company’s earnings per share. It indicates the earnings (past or future) adjusted price market is willing to pay. A high P/E ratio may imply that a stock’s price is expensive relative to earnings. Conversely, a low P/E ratio could mean that the current stock price is undervalued.
The P/B ratio is used to check whether a stock is over or undervalued by comparing the company’s market capitalisation with its net asset value; i.e., the ratio of a stock’s share price by its book value. This ratio indicates what investors are willing to pay for each rupee of a company’s net asset value.
Why simple ideas may not work
In the last decade traditional value stocks with low P/E and P/B ratios as well as high dividend yields have been hurt the most. Growth stocks have significantly outperformed value stocks during this period due to their prospect of generating higher future earnings. In recent years, book value has lost its meaning with asset-light firms and sectors generating extraordinary returns. Hence, value stocks should not be identified merely by low P/E and P/B ratios but also by strong qualitative factors such as earnings stability and future growth prospects.
Growth adjusted value investing
Traditional value investing alone is insufficient to gain high risk-adjusted returns over the long term. Investors should focus on a growth-adjusted value investment strategy which emphasizes on the selection of relatively undervalued stocks but having strong fundamentals such as strong and stable earnings growth, high and increasing profitability ratio, stable return-on-capital employed, and prudent capital allocation by the promoters. Focusing on those firms which have high and sustainable growth potential for a longer run could be a better choice for the investors. Sustainable growth potential combined with value does give investors the best opportunity to earn higher and stable returns.
Hence, it is essential to combine this value investing concept with growth in order to get the maximum benefit of investment. As an appropriate strategy, investors should first focus on the sustainable growth potential of different companies and shortlist them. They could invest in those companies when they are traded for relatively lower valuation.
However, sometimes high P/E and P/B ratios of a company may not be that high if you consider the true potential for sustainable growth of the company. Investors should be careful using these ratios for comparing different companies. The growth prospect of the company should not be ignored.
Saraf is a recent graduate, Madras School of Economics and Kayal is assistant professor, Madras School of Economics