The best thing about investing strategies is that they’re flexible. If you choose one and it doesn’t suit your risk tolerance or schedule, you can certainly make changes. But be forewarned: doing so can be expensive. Every purchase carries a fee. More importantly, selling assets can create a realized capital gain. These gains are taxable and therefore, expensive.

Here, we look at four common investing strategies that suit most investors. By taking the time to understand the characteristics of each, you will be in a better position to choose one that’s right for you over the long-term without the need to incur the expense of changing course.

Take Some Notes

Before you begin to research your investment strategy, it's important to gather some basic information about your financial situation. Ask yourself these key questions:

• What is your current financial situation?
• What is your cost of living including monthly expenses and debts?
• How much can you afford to invest—both initially and on an on-going basis?

Even though you don't need a lot of money to get started, you shouldn't get start if you can't afford to do so. If you have a lot of debts or other obligations, consider the impact investing will have on your situation before you start putting money aside.

Next, set out your goals. Everyone has different needs, so you should determine what yours are. Are you intending to save for retirement? Are you looking to make big purchases like a home or car in the future? Or are you saving for your or your children's education? This will help you narrow down a strategy.

Figure out what your risk tolerance is. This is normally determined by several key factors including your age, income, and how long you have until you retire. Technically, the younger you are, the more risk you can take on. More risk means higher returns, while lower risk means the gains won't be realized as quickly. But keep in mind, high-risk investments also mean there's a greater potential for losses as well.

Finally, learn the basics. It's a good idea to have a basic understanding of what you're getting into so you're not investing blindly. Ask questions. And read on to learn about some of the key strategies out there.

Strategy 1: Value Investing

Value investors are bargain shoppers. They seek stocks they believe are undervalued. They look for stocks with prices they believe don’t fully reflect the intrinsic value of the security. Value investing is predicated, in part, on the idea that some degree of irrationality exists in the market. This irrationality, in theory, presents opportunities to get a stock at a discounted price and make money from it.

It’s not necessary for value investors to comb through volumes of financial data to find deals. Thousands of value mutual funds give investors the chance to own a basket of stocks thought to be undervalued. The Russell Value Index, for example, is a popular benchmark for value investors and several mutual funds mimic this index.

As discussed above, investors can change strategies anytime but doing so—especially as a value investor—can be costly. Despite this, many investors give up on the strategy after a few poor-performing years. In , Wall Street Journal reporter Jason Zweig explained, “Over the decade ended December 31, value funds specializing in large stocks returned an average of % annually. But the typical investor in those funds earned just % annually.” Why did this happen? Because too many investors decided to pull their money out and run. The lesson here is that in order to make value investing work, you must play the long game.

Warren Buffet: The Ultimate Value Investor

But if you are a true value investor, you don't need anyone to convince you need to stay in it for the long run because this strategy is designed around the idea that one should buy businesses—not stocks. That means the investor must consider the big picture, not a temporary knockout performance. People often cite legendary investor Warren Buffet as the epitome of a value investor. He does his homework—sometimes for years. But when he’s ready, he goes all in and is committed for the long-term.

Consider Buffett’s words when he made a substantial investment in the airline industry. He explained that airlines "had a bad first century." Then he said, "And they got a bad century out of the way, I hope." This thinking exemplifies much of the value investing approach. Choices are based on decades of trends and with decades of future performance in mind.

Value Investing Tools

For those who don’t have time to perform exhaustive research, the price-earnings ratio (P/E) has become the primary tool for quickly identifying undervalued or cheap stocks. This is a single number that comes from dividing a stock’s share price by its earnings per share (EPS). A lower P/E ratio signifies you’re paying less per $1 of current earnings. Value investors seek companies with a low P/E ratio.

While using the P/E ratio is a good start, some experts warn this measurement alone is not enough to make the strategy work. Research published in the Financial Analysts Journal determined that “Quantitative investment strategies based on such ratios are not good substitutes for value-investing strategies that use a comprehensive approach in identifying underpriced securities.”  The reason, according to their work, is that investors are often lured by low P/E ratio stocks based on temporarily inflated accounting numbers. These low figures are, in many instances, the result of a falsely high earnings figure (the denominator). When real earnings are reported (not just forecasted) they’re often lower. This results in a “reversion to the mean.” The P/E ratio goes up and the value the investor pursued is gone.

If using the P/E ratio alone is flawed, what should an investor do to find true value stocks? The researchers suggest, “Quantitative approaches to detecting these distortions—such as combining formulaic value with momentum, quality and profitability measures—can help in avoiding these ‘value traps.’”

What's the Message?

The message here is that value investing can work so long as the investor is in it for the long-term and is prepared to apply some serious effort and research to their stock selection. Those willing to put the work in and stick around stand to gain. One study from Dodge & Cox determined that value strategies nearly always outperform growth strategies “over horizons of a decade or more.” The study goes on to explain that value strategies have underperformed growth strategies for a year period in just three periods over the last 90 years. Those periods were the Great Depression (/40), the Technology Stock Bubble () and the period /

Strategy 2: Growth Investing

Rather than look for low-cost deals, growth investors want investments that offer strong upside potential when it comes to the future earnings of stocks. It could be said that a growth investor is often looking for the “next big thing.” Growth investing, however, is not a reckless embrace of speculative investing. Rather, it involves evaluating a stock’s current health as well as its potential to grow.

A growth investor considers the prospects of the industry in which the stock thrives. You may ask, for example, if there’s a future for electric vehicles before investing in Tesla. Or, you may wonder if A.I. will become a fixture of everyday living before investing in a technology company. There must be evidence of a widespread and robust appetite for the company's services or products if it’s going to grow. Investors can answer this question by looking at a company's recent history. Simply put: A growth stock should be growing. The company should have a consistent trend of strong earnings and revenue signifying a capacity to deliver on growth expectations.

A drawback to growth investing is a lack of dividends. If a company is in growth mode, it often needs capital to sustain its expansion. This doesn’t leave much (or any) cash left for dividend payments. Moreover, with faster earnings growth comes higher valuations which are, for most investors, a higher risk proposition.

Does Growth Investing Work?

As the research above indicates, value investing tends to outperform growth investing over the long-term. These findings don’t mean a growth investor can't profit from the strategy, it merely means a growth strategy doesn’t usually generate the level of returns seen with value investing. But according to a study from New York University’s Stern School of Business, “While growth investing underperforms value investing, especially over long time periods, it is also true that there are sub-periods, where growth investing dominates.” The challenge, of course, is determining when these “sub-periods” will occur. 

Interestingly, determining the periods when a growth strategy is poised to perform may mean looking at the gross domestic product (GDP). Take the time between and , when a growth strategy beat a value strategy in seven years (, and ). During five of these years, the GDP growth rate was below 2%. Meanwhile, a value strategy won in nine years, and in seven of those years, the GDP was above 2%. Therefore, it stands to reason that a growth strategy may be more successful during periods of decreasing GDP.

Some growth investing style detractors warn that “growth at any price” is a dangerous approach. Such a drive gave rise to the tech bubble which vaporized millions of portfolios. “Over the past decade, the average growth stock has returned % vs. just 89% for value,” according to Money magazine’s Investor’s Guide 

Growth Investing Variables

While there is no definitive list of hard metrics to guide a growth strategy, there are a few factors an investor should consider. Research from Merrill Lynch, for example, found that growth stocks outperform during periods of falling interest rates. It's important to keep in mind that at the first sign of a downturn in the economy, growth stocks are often the first to get hit.

Growth investors also need to carefully consider the management prowess of a business’s executive team. Achieving growth is among the most difficult challenges for a firm. Therefore, a stellar leadership team is required. Investors must watch how the team performs and the means by which it achieves growth. Growth is of little value if it’s achieved with heavy borrowing. At the same time, investors should evaluate the competition. A company may enjoy stellar growth, but if its primary product is easily replicated, the long-term prospects are dim.

GoPro is a prime example of this phenomenon. The once high-flying stock has seen regular annual revenue declines since “In the months following its debut, shares more than tripled the IPO price of $24 to as much as $87,” the Wall Street Journal reported. The stock has traded well below its IPO price. Much of this demise is attributed to the easily replicated design. After all, GoPro is, at its core, a small camera in a box. The rising popularity and quality of smartphone cameras offer a cheap alternative to paying $ to $ for what is essentially a one-function piece of equipment. Moreover, the company has been unsuccessful at designing and releasing new products which is a necessary step to sustaining growth—something growth investors must consider.

Strategy 3: Momentum Investing

Momentum investors ride the wave. They believe winners keep winning and losers keep losing. They look to buy stocks experiencing an uptrend. Because they believe losers continue to drop, they may choose to short-sell those securities. But short-selling is an exceedingly risky practice. More on that later.

Think of momentum investors as technical analysts. This means they use a strictly data-driven approach to trading and look for patterns in stock prices to guide their purchasing decisions. In essence, momentum investors act in defiance of the efficient-market hypothesis (EMH). This hypothesis states that asset prices fully reflect all information available to the public. It’s difficult to believe this statement and be a momentum investor given that the strategy seeks to capitalize on undervalued and overvalued equities.

Does it Work?

As is the case with so many other investing styles, the answer is complicated. Let’s take a closer look.

Rob Arnott, chair, and founder of Research Affiliates researched this question and this is what he found. “No U.S. mutual fund with ‘momentum’ in its name has, since its inception, outperformed their benchmark net of fees and expenses.”

Interestingly, Arnott’s research also showed that simulated portfolios that put a theoretical momentum investing strategy to work actually “add remarkable value, in most time periods and in most asset classes.” However, when used in a real-world scenario, the results are poor. Why? In two words: trading costs. All of that buying and selling stirs up a lot of brokerage and commission fees.

Traders who adhere to a momentum strategy need to be at the switch, and ready to buy and sell at all times. Profits build over months, not years. This is in contrast to simple buy-and-hold strategies that take a set it-and-forget it approach.

For those who take lunch breaks or simply don’t have an interest in watching the market every day, there are momentum style exchange-traded funds (ETFs). These shares give an investor access to a basket of stocks deemed to be characteristic of momentum securities.

The Appeal of Momentum Investing

Despite some of its shortcomings, momentum investing has its appeal. Consider, for example, that “The MSCI World Momentum Index has averaged annual gains of % over the past two decades, almost twice that of the broader benchmark.” This return probably doesn’t account for trading costs and the time required for execution.

Recent research finds it may be possible to actively trade a momentum strategy without the need for full-time trading and research. Using U.S. data from the New York Stock Exchange (NYSE) between and , a study found that a simplified momentum strategy outperformed the benchmark even after accounting for transaction costs. Moreover, a minimum investment of $5, was enough to realize the benefits.

The same research found that comparing this basic strategy to one of more frequent, smaller trades showed the latter outperformed it, but only to a degree. Sooner or later the trading costs of a rapid-fire approach eroded the returns. Better still, the researchers determined that “the optimal momentum trading frequency ranges from bi-yearly to monthly”—a surprisingly reasonable pace.

Shorting

As mentioned earlier, aggressive momentum traders may also use short selling as a way to boost their returns. This technique allows an investor to profit from a drop in an asset’s price. For example, the short seller—believing a security will fall in price—borrows 50 shares totaling $ Next, the short seller immediately sells those shares on the market for $ and then waits for the asset to drop. When it does, they repurchase the 50 shares (so they can be returned to the lender) at, let’s say, $ Therefore, the short seller gained $ on the initial sale, then spent $25 to get the shares back for a gain of $

The problem with this strategy is that there is an unlimited downside risk. In normal investing, the downside risk is the total value of your investment. If you invest $, the most you can lose is $ However, with short selling, your maximum possible loss is limitless. In the scenario above, for example, you borrow 50 shares and sell them for $ But perhaps the stock doesn’t drop as expected. Instead, it goes up.

The 50 shares are worth $, then $ and so on. Sooner or later the short seller must repurchase the shares to return them to the lender. If the share price keeps increasing, this will be an expensive proposition.

The Lesson?

A momentum strategy may be profitable, but not if it comes at the limitless downside risk associated with short selling.

Strategy 4: Dollar-Cost Averaging

Dollar-cost averaging (DCA) is the practice of making regular investments in the market over time, and is not mutually exclusive to the other methods described above. Rather, it is a means of executing whatever strategy you chose. With DCA, you may choose to put $ in an investment account every month. This disciplined approach becomes particularly powerful when you use automated features that invest for you. It’s easy to commit to a plan when the process requires almost no oversight.

The benefit of the DCA strategy is that it avoids the painful and ill-fated strategy of market timing. Even seasoned investors occasionally feel the temptation to buy when they think prices are low only to discover, to their dismay, they have a longer way to drop.

When investments happen in regular increments, the investor captures prices at all levels, from high to low. These periodic investments effectively lower the average per share cost of the purchases. Putting DCA to work means deciding on three parameters:

• The total sum to be invested
• The window of time during which the investments will be made
• The frequency of purchases

A Wise Choice

Dollar-cost averaging is a wise choice for most investors. It keeps you committed to saving while reducing the level of risk and the effects of volatility. But for those in the position to invest a lump sum, DCA may not be the best approach.

According to a Vanguard study, “On average, we find that an LSI (lump sum investment) approach has outperformed a DCA approach approximately two-thirds of the time, even when results are adjusted for the higher volatility of a stock/bond portfolio versus cash investments.”

But most investors are not in a position to make a single, large investment. Therefore, DCA is appropriate for most. Moreover, a DCA approach is an effective countermeasure to the cognitive bias inherent to humans. New and experienced investors alike are susceptible to hard-wired flaws in judgment. Loss aversion bias, for example, causes us to view the gain or loss of an amount of money asymmetrically. Additionally, confirmation bias leads us to focus on and remember information that confirms our long-held beliefs while ignoring contradictory information that may be important.

Dollar-cost averaging circumvents these common problems by removing human frailties from the equation. Regular, automated investments prevent spontaneous, illogical behavior. The same Vanguard study concluded, “If the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use.”

Once You've Identified Your Strategy

So you've narrowed down a strategy. Great! But there are still a few things you'll need to do before you make the first deposit into your investment account.

First, figure out how much money you need to cover your investments. That includes how much you can deposit at first as well as how much you can continue to invest going forward.

You'll then need to decide the best way for you to invest. Do you intend to go to a traditional financial advisor or broker, or is a passive, worry-free approach more appropriate for you? If you choose the latter, consider signing up with a robo-advisor. This will help you figure out the cost of investing from management fees to commissions you'll need to pay your broker or advisor. Another thing to keep in mind: Don't turn away employer-sponsored ks — that's a great way to start investing. Most companies allow you to invest part of your paycheck and tuck it away tax-free and many will match your contributions. You won't even notice because you don't have to do a thing.

Consider your investment vehicles. Remember that it doesn't help to keep your eggs in one basket, so make sure you spread your money around to different investment vehicles by diversifying—stocks, bonds, mutual funds, ETFs. If you're someone who is socially conscious, you may consider responsible investing. Now is the time to figure out what you want your investment portfolio to be made of and what it will look like.

Investing is a roller coaster, so keep your emotions at bay. It may seem amazing when your investments are making money, but when they take a loss, it may be difficult to handle. That's why it's important to take a step back, take your emotions out of the equation and review your investments with your advisor on a regular basis to make sure they're on track.

The Bottom Line

The decision to choose a strategy is more important than the strategy itself. Indeed, any of these strategies can generate a significant return as long as the investor makes a choice and commits to it. The reason it is important to choose is that the sooner you start, the greater the effects of compounding.

Remember, don’t focus exclusively on annual returns when choosing a strategy. Engage the approach that suits your schedule and risk tolerance. Ignoring these aspects can lead to a high abandon rate and frequently changed strategies. And, as discussed above, numerous changes generate costs that eat away at your annual rate of return.

Image Source: Outlook India

After talking about the important concept of economic moats in the first part of his interview, in this second and concluding part, Prof. Bakshi talks about his thoughts on valuations, mental models, diversification, checklists, and why you must buy great businesses for the long term.

Safal Niveshak:One of the problems that new or small investors have is that they can’t really get their heads around valuation. It seems so complex. A lot of the terminology is complex, the concepts are, and there is a lot of contrary thinking needed to effectively value businesses.

How can valuations be made easier? How have you made it easier? Or can it not be made easier?

Prof. Bakshi: Vishal, that particular problem is equally applicable to large investors!

Anyway, over the years I have dealt with the problem in many ways. As a disciple of Ben Graham, when working on any business and not necessarily moats, I developed my own ways of thinking about valuation.

Graham used to talk about protection vs prediction. He used to say that investors should seek protection in the form of margin of safety either through conservatively calculated intrinsic value (usually based on asset value) over market price or superior rate of sustainable earnings on price paid for a business vs a passive rate of return on that money.

That approach works well in many businesses as even though their future fundamental performance is largely unpredictable because one is, in effect, underwriting insurance.

Graham’s methods helped investors deal with the unpredictability problem in security analysis. For example, when you bought the stock of a company selling below net cash and the operating business was not losing money, then you were effectively getting the business for free. Even if the business may have been mediocre, it was free. And the typical Graham-and-Dodd investor absolutely loves freebies.

That kind of approach enabled you to justify a purchase because value was more than price even though one did not know by how much. Poor management quality was dealt with through insistence on an even lower price in relation to value.

For Graham, there were no good or bad businesses, only good or bad investments. And that approach can work if you practice wide diversification and buy out-of-favor businesses which are perhaps not doing very well right now but eventually might.

So there was an inherent belief in the idea of mean reversion i.e., poorly performing businesses would improve their performance over time.

In case of predictable businesses with stable cash flows, I used to talk about “debt-capacity bargains” and still teach that concept to my students. That’s because I think the idea of “debt capacity” is a very powerful mental construct in valuation.

The basic idea here was that the value of a debt-free business has to be more than its debt capacity. I discussed it in detail in one of my more popular lectures titled “Vantage Point” so I won’t get into the details here.

Similarly, buying into businesses where pre-tax earnings yield was in excess of twice of AAA bond yield, and the business had a strong balance sheet was one of the key methods of Graham for identifying a bargain security.

If you had a reasonable degree of confidence that average past earning power will return soon and the business had staying power (that’s why the insistence on a strong balance sheet), then sooner or later the market will recognize that the stock had been beaten down too much and there would be a more than satisfactory appreciation in its market value.

And even if you go wrong on a few of these positions, because you had so many, things would work out well eventually.

But as you move towards enduring moats, you move towards predictability and higher quality. In such situations, the need for protection in the form of high asset value or high average past earnings in relation to the asking price goes away.

Of course, that does not mean that you don’t need a margin of safety any more. Far from it. It’s just that the source of that margin of safety now resides in the quality of the business you’re buying into, its long-term competitive advantages, its ability to grow its earnings while delivering high returns on incremental capital without need for issuance or new shares or significant debt.

It also comes from the superior ability of the management to create a moat and to do all things necessary which will widen it over time.

Finally, the safety margin comes from buying the business at a valuation that would, in time, prove to be a bargain, even though today it may appear to be expensive to many investors.

It’s obvious that the art of making even reasonable estimates of future earning power of businesses a decade or more from now cannot possibly be extended to most businesses.

But I think — and I’ve learnt this over the years by studying investors like Charlie Munger and Warren Buffett — you can do that for a handful of businesses. And as Mr. Munger and Mr. Buffett like to say you don’t need very many.

Then, if that’s true, and I think it is true, you can reach out reduce the problem to just a handful of variables that will help you come with a range of potential future earnings and market values and from that you can derive a range of long-term expected returns. And I tried to explain that in my final Relaxo Lecture.

So, to summarize, if you are going to invest like Ben Graham, then your sources of margin of safety are different than if you invest like Warren Buffett. You just have to be aware of those sources and also of their limitations.

I also strongly feel that when it comes to moats, it makes sense to think in terms of expected returns and not fuzzy intrinsic value.

What will not work is to apply the same methodology to every business.

For example, in my view there is a way to invest conservatively in businesses which are likely to experience a great deal of uncertainty. But you simply can’t use that approach when dealing with enduring moats. And vice versa.

You need to have multiple models to deal with different situations to avoid the “to-a-man-with-a-hammer-everything-looks-like-a-nail” trap.

Safal Niveshak:Stephen Penman, in his book “Accounting for Value” talks about his dislike for the DCF method of valuing stocks. His reasoning is that FCF, the basis for DCF is calculated after reducing capex/investments, even when investments, if directed well, create immense value for companies. His second grudge is against forecasting cash flows for years, which he thinks is speculation.

What are your thoughts – good or bad – on DCF? If not DCF, what?

Prof. Bakshi: Prof. Penman’s book is an excellent one and I would recommend it to all value investors.

I completely agree with him when he says that standard valuation models use FCF and FCF is not the same as owner earnings. It’s the owner earnings that really count. That’s the number you’ve to focus on.

A business may have low FCF but very high owner earnings simply because the business is growing and a big part of operating cash flow is going into growth capex. Or a business may have low FCF because it has low owner earnings in relation to tangible capital employed and the business has to spend a lot of money to replace obsolete plant and machinery.

The difference between these situations is night and day, even though the outcome in both is the same: low FCF.

I think investors should spend a lot of time thinking about owner earnings in a variety of businesses and look for good reasons which explain situations where owner earnings are materially different from reported earnings.

They should ignore FCF as well, except when they are evaluating the firm’s need to access outside capital markets to fund growth. That’s the only good reason to look at FCF in my view.

Over the years, Mr. Buffett has written extensively about owner earnings in his letters. See, for example, Appendix to his letter. There’s also very good book on the subject that I like a lot and I would recommend to your readers. It’s titled “It’s Earnings That Count” by Hewitt Heiserman.

DCF has problems of its own of course. Most of them are behavioral. Investors tend to tell stories quite well using DCF. The most popular software for writing fiction isn’t Word. It’s Excel. 🙂

DCF models must come with standard warning: Use with extreme care. This may explode in your face.

Graham recognized that and warned against such behavior. Prof. Penman does the same in his book as well. While it’s easy to fool yourself, there are ways to prevent that.

The first one is to limit its usage to only those businesses which have predictable business models.

The second one is to exercise conservatism while predicting future growth rates and profitability.

Third, one can side-step the issue about making predictions far into the future and think in terms of expected returns over a decade or so (no more playing around with terminal growth rates). While doing that, when determining value a decade from now, one must not assume a high P/E multiple.

And fourth, when facts change, you must change your mind. No matter how sure you feel about your predictions, when you encounter evidence that proves that you were over-confident, you must change your conclusions and not look for new reasons to justify your previous, wrong conclusions.

I think it’s also a good idea to use the inversion principle which involves taking the current market value of the firm and reverse engineer into the implied assumptions and then objectively question those assumptions. Thinking backwards de-biases you.

Safal Niveshak:Last time we met, you talked about a few behavioral biases that affect investors. This time, can you take us through a few mental models outside psychology that “must” form part of an investor’s latticework? How does one go about developing such models?

Prof. Bakshi: Of course you have to step outside the world of psychology. One discipline which you’ve to read is micro-economics.

Micro-economics is not complete without psychology. They complement each other.

Standard micro-economics textbooks, for example, tell you that there comes a point when a business must be shut down (the “shut down point”).

However, if you read Buffett and psychology, you’ll find that in many businesses the shut-down point comes much earlier. Buffett explained that beautifully in his essay titled “Shutdown of Textile Operations” in his letter.

Studying micro-economics will provide you with several mental models like opportunity cost, pricing power, creative destruction, Gresham’s law, comparative advantage, invisible hand, tragedy of the commons, economies and diseconomies of scale, Tobin’s Q, specialization and experience curve, and many more.

Within the field of micro-economics, I think you really have to read a lot on competitive advantage. What creates an advantage? What sustains it? What destroys it?

There are many wonderful books you just have to read on the subject to pick up a few very useful models. For example Pat Dorsey’s “The Little Book That Builds Wealth” is a superbly written book which helps you create a framework around competitive advantages.

Another excellent book which summarizes Porter’s ideas on the subject is by Joan Magretta and is titled “Understanding Michael Porter: The Essential Guide to Competition and Strategy”.

I think that there’s a great need to synthesize the ideas of Munger, Buffett and Dorsey on moats and Porter on competitive advantage.

I also loved “Different: Escaping the Competitive Herd” by Yongme Moon and The “The Tipping Point” by Gladwell. And I absolutely loved “Abundance: The Future is Better Than You Think” By Peter Diamandis. All these books will make you think.

Books on evolutionary biology (my favorites are “The Selfish Gene” and “The Blind Watchmaker” by Richard Dawkins) and quantum physics (read “Taking the Quantum Leap” by Fred Wolf) will give you some very useful mental models too.

Read “The Brain That Changes Itself” by Norman Diodge to learn about the plasticity of the brain and you then use what you learn from that book along with “One Small Step Can Change Your Life: The Kaizen Way” by Robert Maurer to learn how the slow contrast effect works on your brain. Read “Hooked: How to Build Habit-Forming Products” by Nir Eyal to learn how businesses condition consumers to choose their products subconsciously.

Read “Business Model Generation: A Handbook for Visionaries, Game Changers, and Challengers” to ignite your mind about a variety of business models.

You can also pick up a lot of mental models by following and reading blogs like Farnam Street.

I could go on about acquiring mental models by reading books but I’ll stop here!

Read annual reports of companies with a curious mind always asking how, why or why not questions.

How did Shriram Transport Finance create a low-risk business from giving loans to used-truck drivers? How did Symphony Limited learn from its mistakes to become India’s most profitable businesses in its industry in less than a decade? Why is Thomas Cook’s integrated business model of travel and forex much more profitable than stand-alone forex and stand-alone travel companies?

As Charlie Munger says you just have to read a lot and relate what you read to what you observe, always with a curious mind.

Try to come up with notions or provisional theories which explain whatever you’re trying to explain and then look for evidence that supports or destroy those notions. Peter Bevelin, author of a wonderful book on Sherlock Holmes would agree. Here are a few quotes from his book.

“Without an idea of how reality works, a purpose, provisional idea of what is important and what to look for, our observation or collection of facts is of little use.”

“A hypothesis is&#;the obligatory starting point of all experimental reasoning. Without it no investigation would be possible, and one would learn nothing: one could only pile up barren observations. To experiment without a preconceived idea is to wonder aimlessly.” (Claude Bernard)

“You have a theory?” “Yes, a provisional one.” (Holmes; The Yellow Face)

“Nothing can be done without preconceived ideas; only there must be the wisdom not to accept their deductions beyond what experiments confirm.” (Louis Pasteur)

Safal Niveshak:Buffett has said “diversification is for the know nothing investor”. Now if I borrow from Jacobi and invert this, I would think “concentration is for the know everything investor”. The question is – Given the regulatory uncertainties and the extremely large pool of shady promoters, would concentration work in the Indian markets?

Prof. Bakshi: The “know everything” investor is also usually an overconfident investor.

My view is that investors, when they start out, should practice wide diversification and move towards concentrated positions only after about a decade of experience and as they move towards concentrated positions, their propensity to take business risk and management risk will go down but their ability to acquire deep knowledge about a handful of businesses with value creating potential will go up.

As for your question about regulatory uncertainties and shady promoters, I invite you to read a very interesting document I read in the early part of my career. Titled “Recovery Investment” it describes a British fund which&#;

&#;never invested in successful, well managed companies such as Marks and Spencer, Sainsbury’s or Shell. The Fund which is called the “Recovery Fund” invests in companies which are experiencing difficulties such as making losses, weak balance sheets, frauds, natural disasters, or a specific industry downturn.

Recovery Fund has been in existence since and over 26 years till (when I read the document) compounded capital at % a year as compared to benchmark return of % a year.

While I don’t practice recovery investment anymore, that doesn’t mean it won’t work for someone who is focussed on turnarounds. When Buffett wrote that “turnarounds seldom turn,” he did not imply that they never turn.

India has its share (perhaps more than its share) of businesses run by fools or crooks but that fact wouldn’t necessarily prevent a creative, thoughtful, and focussed value investor from making money in them. Such a strategy, however, would require wide diversification.

You’re right about concentration. If you want concentrated positions, you don’t want businesses run by fools or crooks in your portfolio.

Safal Niveshak:Seth Klarman and many others (even Buffett) had mentioned that investors with small amounts to invest should look at things that no one is looking at, the ones that slip through the cracks. Where would these areas be in Indian equities? And given the paucity of data and questionable management that could be running these companies, how does one do the due diligence and get comfortable that the data is correct so that we don’t get blindsided?

Prof. Bakshi: That would be micro-caps. And there are a group of very smart value investors in India doing just that.

They buy stocks of obscure and small but rapidly growing companies run by good managements at very low earnings multiples and then see their market values soar over the next few years. Their excellent returns are a direct result of negligible competition as no institutional investor would want to invest in a company with a market cap of Rs 50 cr. Maybe you should interview some of those guys.

I will give you a list after checking with them. Some of them may provide a better answer to your question than I can.

Safal Niveshak:How do you avoid getting caught with your own reasoning? In other words, how do you look into a business from an outsider/ bystander’s point of view without accepting your internal beliefs about the company?

Prof. Bakshi: Well one way to do that is to have a checklist about the business and the management and keep going back to it to verify if the investment thesis is still intact or not.

Nothing is permanent. Moats get impaired. Managements can make big mistakes which destroy the investment thesis. You also need to keep reviewing your estimate of expected long-term return based on the prevailing market price, and if that becomes mediocre for any given stock, perhaps it’s time to replace it with another, more promising one.

One great book I recommend on checklists is “The Investment Checklist” by Michael Shearn.

Another way is to pay special attention to disconfirming evidence and views of someone you respect who does not agree with you. But it’s also important to not end up in a room full of skeptics. In his latest letter Seth Klarman draws a beautiful metaphor between investing and rowing. He writes:

A good investment team is like a crew team – a mix of talents and personalities that come together to produce a result surpassing what any one individual could hope to muster.

You need generalists, but also some specialized knowledge. You need skeptics, but a room full of skeptics would have trouble “getting to yes.” You need good negotiators, and people who can reach closure on a great deal when it’s offered. You need deliberators and decision-makers. You need contrarians, but sometimes the consensus view is exactly what happens. You need visionaries and number crunchers, outside the box thinkers, and some who can stay within the box when appropriate.

You need those with the arrogance to shout “buy” and “sell” in fast-moving markets, and those with the humility to consider whether they could, in fact, be wrong. Most valuable, of course, are those with multiple skills, those who can occupy different seats, even all the seats, in the boat at different times.

A third way is to conduct post-mortem about your mistakes. And you wouldn’t know the quality of your decisions unless you followed the advice of Shane Parrish, the publisher of Farnam Street who talks about the need to keep a “Decision Journal.” He is overwhelmingly right on that one.

In his monumental book “Thinking Fast and Slow” Prof Kahneman talks about Gary Klein’s idea of “pre-mortem” which goes one step further than post-mortem. He writes:

The procedure is simple: when the organization has almost come to an important decision but has not formally committed itself, Klein proposes gathering for a brief session a group of individuals who are knowledgeable about the decision.

The premise of the session is a short speech: “Imagine that we are a year into the future. We implemented the plan as it now exists. The outcome was a disaster. Please take 5 to 10 minutes to write a brief history of that disaster.&#;

I have to confess, however, that I haven’t conducted pre-mortems yet!

Safal Niveshak:In The Intelligent Investor, Ben Graham gives considerable importance to dividends. In contrast, Philip Fisher does not find anything important about dividends. It would be great to have your views on the same.

Prof. Bakshi: What matters is total return on the stock over time and dividends are a part of that.

If you’re investing in non-moat, slow growing businesses, dividends often become quite important. The dividend stream alone may explain a large part of the company’s stock price, and so the rest of earnings which are not being paid out may be acquired at a very low multiple.

It’s useful to value that dividend stream like a bond and net off the derived value of that bond from the stock price to determine what the market is paying for the rest of the earnings.

When investing in moats, there are three situations:

1. Non-scalable moats— businesses which won’t grow a lot over the years but will pay a large part of earnings as dividends over time (one current example is Noida Toll Bridge Company).
2. Scalable moats which can take in capital i.e., the business can grow rapidly but they need incremental capital for that growth and that capital is usually provided by keeping dividend payout ratio low. So long as returns on incremental capital in such situations are excellent, investors should not worry about low dividends. They will make money though capital gains instead. An example of such a business is Relaxo Footwear.
3. Scalable moats which don’t need a lot of capital for growth because the business model is asset-light. Such businesses can deliver excellent returns through growing dividends and capital gains. One example is that of Kewal Kiran Clothing which was a case in my class last year.

By the way, I am not recommending any of these stocks and cite them only as illustrations.

Personally, I have moved away from non-scalable moats because I apply a filter by asking a simple question: Can this stock become a ten-bagger? And there is no way a stock can become a ten-bagger in a rational market unless revenues were to grow rapidly over time. So, for me, high dividends in non-scalable moats are not terribly exciting.

When it comes to scalable moats, the relative importance of dividends as part of total return would depend upon whether the business is capital intensive or not. So the correct answer, in my view, is that investors should focus on total return.

Safal Niveshak:Talking about one concern that seems to be on top of most investors’ mind – the currency printing worldwide that’s creating bubbles all around, especially in equities.

• How does an investor deal with this uncertainty of these bubbles bursting?
• How does one maintain a “DCF frame of mind” when cash is fast losing value?

Prof. Bakshi: Bubbles are a function of human nature and human nature hasn’t changed much since the days of the South Sea Bubble.

We’re going to see a lot of bubbles over our lifetimes. But that doesn’t mean that there won’t be opportunities to make money in stocks.

Investors should be cognizant about bubbles in various asset classes (real estate, commodities, equities, gold etc) and position themselves to not be hurt when the bubbles burst.

That, by the way, is one reason why I like moats. Companies that buy commodities and sell brands, for example aren’t likely to be hurt by a commodity price bubble occurring or bursting.

If the business has pricing power, then if commodity input prices rise, the business has the ability to pass it on to customers without fear of volume decline or loss of market share.

If the bubble bursts, and commodity prices crash, then the business can either pass all of the benefit to customers to drive volume growth or retain some of it for itself.

That’s the thing about moats. They are resilient. They can withstand shocks way better than other businesses which don’t have moats.

The “DCF frame of mind” is a very useful mental construct. After all, if everyone had perfect foresight, there would be no ambiguity about the value of any productive asset. Simply bring back to present value all its future cash flows.

Of course, no one has perfect foresight and one can have limited foresight about just a handful of businesses out there. Even so, the DCF mindset can help investors deal with understanding other less predictable businesses as well.

Markets can oscillate between extreme optimism and pessimism and having the DCF mindset can be really useful for the thoughtful investors. Stock prices often fall to such low levels that the earnings of the next three to four years alone in a business which is certain to last much longer, start explaining almost all of the stock price.

Conversely, sometimes market valuations go to such extremes that even high earnings growth rate for a couple of decades would not produce earnings sufficient enough to justify a future value large enough to make a commitment today. So, having the &#;DCF frame of mind&#; is very useful in my view.

You talk about cash fast losing value because of inflation. Cash is a very hard asset to value. Most people think that a Rs note is worth Rs , no more and no less. That would be true if the money was in their hands. But the money is not in their hands. It’s in the hands of a company whose stock they own.

In such situations, what’s the cash worth in an inflationary world? The answer depends on what the company does with that cash. The choices are:

1. Deploy it in assets which would earn a much higher return than AAA bond yield net of inflation. Even if the deployment is a bit delayed, the prospect of that happening makes that cash worth more than its face value;
2. Deploy it in assets which would earn a return lower than AAA bond yield net of inflation, in which case value is destroyed and the cash should be valued at a discount; and
3. Hoard it and keep it in treasury with no intention of deploying it anywhere, in which case, again value is being destroyed and the cash on the balance sheet is worth less than its book value.

Safal Niveshak:Do you continue to believe in the long-term India story? If yes, why? If not, why not?

Prof. Bakshi: Do I continue to agree with the long-term India story? Not only do I agree, over the last one year, my partner and I have made numerous presentations to global investors in an attempt to convince them to make long-term commitments through Indian public markets.

In our view, global investors mustn’t ignore India anymore. Sure, we’d had our Satyams and NSELs but we’ve also had our Asian Paints and Pidilites. The number of companies that have created enormous long-term wealth in India for their stockholders is large enough to be noticed.

India has many fantastic entrepreneurs who, under very difficult circumstances have been able to compound capital entrusted to them at superlative rates for long time periods. They have done it without cutting corners. And they have done it with a sense of capital stewardship that should remind the global investors about Rose Blumkin of Nebraska Furniture Mart.

Like Mrs. Blumkin, many of these entrepreneurs did not get “proper” education in English-speaking schools. Like Mrs. Blumkin, they too can’t articulate their thoughts very well to the global investment community. But boy do they know how to run a business!

They know how to create brands and how to get a sustainable cost advantage. They know how to distribute their products efficiently. They know how to manufacture efficiently. They know how to implement the best management practices. Cost cutting comes as naturally to them as breathing.

They know how to advertise. They know how to make intelligent capital allocation decisions. They know that “growth for the sake of growth alone is the ideology of a cancerous cell” and they they run their businesses for profitable growth and not for just taking market share. They know how to focus on long-term value creation and not short-term earnings.

I believe they are the unsung heroes of India’s capitalism. Partnering with them and showcasing them to the world is something that ought to be done. It’s kind of patriotic, isn’t it?

And, I am doing it…

Safal Niveshak:Would you tell my readers the Nano vs. Jaguar story that you’ve created?

Prof. Bakshi:Of course!

Question: A Nano is about to enter into a race with a Jaguar. Because the faster of the two is Jaguar, to create a “level playing field,” the race organizers decide to give Nano an advantage.

They do this by allowing it to start the race 5 km ahead of Jaguar. Which car will win the race when both are allowed to go at their top speeds? Think before reading further!

Answer: It depends on how far is the finishing line.

A scalable commodity-type business without a moat is like the Nano. While it have an advantage of a “cheap” price in the form of a low P/E or P/B multiple, it’s “engine” sputters quite a bit and may die rather unexpectedly. Nano is not going to win a long race against Jaguar.

On the other hand, a scalable moat business is like the Jaguar. The disadvantage it suffers from is the “high” P/E and P/B multiple one has to pay to get into its driver’s seat. In long races, this disadvantage doesn’t prevent Jaguar from beating the shit out of Nano but in very short races, Nano wins.

The moral of the story is this: If you’re going to be making truly long-term bets, you should buy Jaguars. But you should also ensure that they are not too far behind Nanos when the race starts. Because, if they are too far behind, then it will be very difficult for Jaguars to catch up.

Investors should recognize that when they buy poor businesses (Nanos) at below book value, then while their original investment may have been made on a bargain basis, every successive investment made by them in the business through earnings retention happens at book value. That’s because earnings retention is functionally equivalent to a dividend payout of % of earnings immediately followed by a proportionate, compulsory rights issue at book value.

In contrast, when investors buy great businesses (Jaguars) at above book value, then while their original investment may look expensive (and often turns out to be too expensive), every successive investment made by them in the business through earnings retention happens at book value.

Over time, the aggregate earnings retention by a business since its acquisition will start mattering more than its purchase price. In poor businesses, it would hurt. In good ones, it would help.

To illustrate, in the short-run, the stock of a poorly run bank which earns a ROE of only 10% a year bought at times book value may outperform the stock of a brilliantly run and highly profitable NBFC (ROE of 25%) acquired at 2 times book value. But in the long run, the NBFC will almost always outperform the bank (assuming the qualities of both businesses remain unchanged).

Safal Niveshak:Amidst the rigours of daily life, small investors often find it difficult to devote much time to reading, which is so essential to develop the right investing mindset. So if you were to suggest them just books or resources that can provide them % of their learning, which ones would those be?

Prof. Bakshi: You should read books in a month! And if you don’t get time to read, then pick some tricks from here written by a friend who reads books in a week!

But if you put a gun on my head, then I would advice investors to buy a Kindle and then buy all the letters of Warren Buffett(Vishal &#; You can also download PDF of his letters from here). They cost just US$ (Rs ) and in my view there is nothing better out there.

Why on Kindle? Because you get access to them all the time. You could be waiting at a traffic crossing in your car waiting for the light to turn green and while you’re doing that you could pick a random passage or two and learn something useful.

Before you sleep at night, you could read a few more passages and then by the time you wake up the ideas you read about would get “fused” in your brain because your mind would be thinking about what you read even when you slept. This works for me. It really does!

Read just that one book slowly and you’ll become wiser.

I also recommend:

1. The Investment Checklist by Michael Shearn;
2. The Little Book That Builds Wealth by Pat Dorsey;
3. Understanding Michael Porter: The Essential Guide to Competition and Strategy by Joan Magretta; and
4. It’s Earnings That Count by Hewitt Heiserman.

Safal Niveshak:Thank you so much Prof. Bakshi! I also thank you on behalf of Safal Niveshak&#;s readers for taking out time from your busy schedule to answer so many important questions on investing and how one can form the right mindset to become a sensible, long-term investor.

Hope to meet you soon. Thank you!

Prof. Bakshi: This was fun. Thanks for your patience. Keep up the good work you’re doing. Let’s create some really good investors!

It&#x;s the perennial question among stock investors: which is better &#x; growth investing or value investing? Recently, there&#x;s been little contest. Growth stocks, such as Amazon and Apple, have handily outperformed value names. But it&#x;s not always that way, and many investors think value will once again have its day, though they have been waiting on that day for quite some time.

Here&#x;s what investors say about growth and value investing, and when we might see value investing begin to outperform again.

Differences between growth investing and value investing

Many see the distinction between growth and value as somewhat arbitrary, but it&#x;s useful to lay out what might differ between the two approaches, even if it seems a bit like a stereotype.

Growth investing

Growth investors look for $ stocks that could be worth $ in a few years if the company continues to grow quickly. As such, the success of their investment relies on the expansion of the company and the market continuing to price growth stocks at a premium valuation, as measured by a P/E ratio maybe, in later years if the company continues to succeed.

Growth stocks are sometimes also called momentum stocks, because their strong upward rise leads to more and more investors piling into them. Sometimes that movement occurs regardless of the company&#x;s fundamentals, as investors build pie in the sky expectations around the company. When those expectations aren&#x;t realized as quickly as some investors expect, a growth stock can plunge, though it may later rise with renewed optimism.

Value investing

In contrast, value investors look for $50 stocks that are actually worth $ today, not in a few years, if the company continues its business plan. These investors are typically buying stocks that are out of favor now and therefore have a low valuation. They&#x;re betting on the market&#x;s opinion becoming more favorable, pushing up the stock price.

Value investing is based on the premise that paying less for a set of future cash flows is associated with a higher expected return, says Wes Crill, head of investment strategists at Dimensional Fund Advisors in Austin, Texas. That&#x;s one of the most fundamental tenets of investing.

Many of America&#x;s most famous investors are value investors, including Warren Buffett, Charlie Munger and Ben Graham, among many others. Still, plenty of very wealthy individuals own growth stocks, including Amazon&#x;s founder Jeff Bezos and hedge fund billionaire Bill Ackman, and even Buffett has shifted his approach to become more growth-oriented these days.

Growth investing and value investing differ in other key ways, too, as detailed in the table below.

But the difference between growth and value investors can sometimes be artificial, as many investors agree. There are times when growth stocks are undervalued and there are plenty of value stocks that grow. Regardless of their style, investors are trying to buy a stock that&#x;s worth more in the future than it is today. And both value companies and growth companies tend to expand at least a little over time and often significantly, making them some of the best long-term investments to buy. So the definitions of the terms are a bit slippery.

Typical investing wisdom might say that when the markets are greedy, growth investors win and when they are fearful, value investors win, says Blair Silverberg, CEO of Hum Capital, a funding company for early-stage firms based in New York City.

The s are a little different, Silverberg says. There are real tailwinds to technology companies and you can actually find value by buying great companies at fair prices.

And sometimes the difference between the two investing styles may be largely psychological.

The market sometimes overlooks the earnings growth potential in a company just because it has been bucketed as a value stock, says Nathan Rex, chief investment officer at Eigenvector Capital in Stamford, Connecticut.

Which is better: growth investing or value investing?

The question of which investing style is better depends on many factors, since each style can perform better in different economic climates. Growth stocks may do better when interest rates are low and expected to stay low, but many investors shift to value stocks as rates rise. Growth stocks have had a stronger run recently, but value stocks have a good long-term record.

Growth stocks continue to outperform

Currently growth stocks have been having a nice go, with the last decade spent running up on the backs of large tech companies with massive opportunities. Tech stocks such as Meta Platforms, Alphabet, Amazon, Apple and Netflix &#x; once named FAANG stocks (when Alphabet used to be called Google and Meta Platforms was Facebook) &#x; now dominate the market and comprise a huge portion of key indexes such as the Standard & Poor&#x;s As another trillion-dollar player, Microsoft is also added to this mix.

In the five years ending , large-cap growth outperformed large-cap value by a cumulative 30 percent, says Ryan Johnson, CFA, director of portfolio management and research at Buckingham Advisors in Dayton, Ohio. Still, the annualized return of value was respectable, at over 9 percent.

So what&#x;s driving growth stocks?

Investors have become so fearful of short-term events and a low-growth economy that they are willing to pay a higher premium for growth in future years, says Rex.

The FAANG stocks, for example, all traded over 24 times earnings in late In contrast, the S&P &#x;s historical P/E ratio is closer to 16 times earnings.

The driver for growth vs. value over the last decade has been the market&#x;s grasp for anything that could demonstrate the ability to increase earnings in a low-growth, disinflationary environment, says Jeff Weniger, head of equity strategy at WisdomTree Investments in Chicago.

Weniger points to tech and communications services stocks as winners on the growth side, while gesturing to energy and financials as stocks that struggle in this environment, two sectors that tend to populate value indexes. The pandemic exacerbated the disparity, as tech stocks may have thrived while old-line companies were hit harder, he says.

The interest rate environment has been terrible for traditional banks, says Norm Conley, CEO and CIO at JAG Capital Management in the St. Louis area. While financials are cheap on some measures, their earnings power has been crimped severely by a flatter, lower yield curve, and the regulatory environment for banks has been anything but supportive since the Great Financial Crisis.

Conley notes that many value indices are heavily-weighted to &#x;old economy,&#x; asset-intensive companies, during a period of massive technological growth and disruption.

Value investing tends to outperform over the long term

While growth stocks might win the short-term battle, value stocks are winning the long-term war, suggests Dr. Robert Johnson, finance professor at Creighton University and co-author of the book Strategic Value Investing.

From through , according to the data compiled by Nobel Prize laureate Eugene Fama and Dartmouth professor Kenneth French, over rolling year time periods, value stocks have outperformed growth stocks 93 percent of the time, he says.

But over a shorter period, value may outperform at a lower percentage. Johnson cites the same research showing that in annual periods value outperformed just 62 percent of the time.

But that&#x;s not to say that value stocks as a whole will be winners when the market turns. It&#x;s important to distinguish value stocks that have permanent problems with those that may be suffering temporary setbacks or those the market has soured on for the time being.

Value investors have always run the risk of plowing capital into stocks that are cheap for a reason and ultimately continue to underperform, says Conley.

Such stocks are called value traps, but the same phenomenon exists with growth stocks, and investors who buy into highly valued growth names may get burned, if the companies are unable to maintain the rapid expansion that Wall Street demands.

Both value and growth investors run the risk of investing capital at prices that, in the fullness of time, will prove to have been too high, says Conley.

When will value outperform growth again?

The question that has been on the minds of many investors is when value stocks will outshine growth stocks. The short answer is, no one knows. The long answer is also, no one knows. But they do know eventually the market will again favor value stocks. Experts point to a few factors to consider when thinking about how value again becomes the more favored approach.

One sign to watch out for: inflation. Weniger says that inflation helps value stocks more than it does growth stocks. Inflation reached its highest level in 40 years in early

Some traditional value sectors have performed well of late, as rising energy prices fueled inflation and increased investors&#x; expectations for higher interest rates. Those rises boosted energy and financial names in , as investors priced in higher profits at these companies.

A favorable change in the near-term outlook would remove a great deal of the fear and pessimism that are currently holding value stocks back, says Rex. With such a change value stocks, which are growing earnings more quickly than growth stocks, will begin to outperform.

And value stocks are exactly where financial experts questioned in Bankrate&#x;s fourth-quarter survey expect to see outperformance through December

When, not if, U.S. large-cap tech falls out of favor, value&#x;s relative performance will improve, says Johnson of Buckingham Advisors.

Many investors point to long-term studies showing that eventually the market does re-rate value stocks.

Our research shows that value investing continues to be a reliable way for investors to increase expected returns going forward, says Crill. He suggests that the longer you stay invested, the more likely value is to outperform, since history tells us value can show up in bunches.

And a plain old correction in stocks or a bear market may return value stocks to favor. With lower expectations built into their prices, value stocks often don&#x;t suffer the kind of downturn that higher-valued stocks do when the market sells off.

Bull market leaders are often bear market laggards, so it could be that the market hitting a rough patch is what causes beleaguered value stocks to outperform, much as they did from to , when that era&#x;s go-go stocks came back to earth, says Weniger.

In fact, that time may have already arrived. In early , stocks declined and fell into correction territory as investor concerns grew about the prospects of higher interest rates and the Russia-Ukraine conflict. Through March 3, , the Vanguard Russell Value ETF (VONV) has declined percent so far this year, while the iShares Russell Growth ETF (IWF) has fallen by percent. The ARK Innovation ETF (ARKK), which holds many once high-flying growth stocks, has fallen by percent in and nearly 50 percent over the past 12 months.

Bottom line

The old debate of growth vs. value will live on, but the empirical evidence suggests that value stocks outperform over time, even if growth stocks steal the daily headlines. If they&#x;re buying individual stocks, investors should stick to fundamental investing principles or otherwise consider buying a solid index fund that takes a lot of the risk out of stocks.

Learn more:

While the long term returns from “value investing” are strong and well documented, the approach has struggled over the past decade prompting many investors to question its merits.

This paper represents the second of what will now be a three part series discussing value investing from an Australian perspective. In the first paper we concluded that value investing on the basis of free-cash-flow has performed well through a number of market cycles and has displayed low levels of volatility when compared to traditional classifications of value such as earnings, book value and dividends.

In this second paper, we begin to explore the question of why value strategies based on free-cash-flow outperform the broader market. Consistent with our philosophy, we present findings that show a linkage between value investing on the basis of free-cash-flow and earnings quality. We then go on to dismiss the notion that value investing is “riskier” than passive alternatives.
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Why do stocks with high free-cash-flow-yields tend to outperform?

The performance of value investing on the basis of free-cash-flow in an Australian context has been compelling and, in our view, represents a strong foundation for active stock selection. This key finding underpins Merlon’s investment philosophy which is built around the notion that companies undervalued on the basis of free cash flow and franking will outperform over time.

A second key tenant of Merlon’s investment philosophy is that markets are mostly efficient. We don’t believe that value stocks outperform simply because they are “cheap” but rather because there are misperceptions in the market about their risk profiles and their growth outlooks.

We are focused on identifying and understanding potential misperceptions in the market. To be a good investment, market concerns need to be priced in or deemed invalid. We incorporate these aspects with a “conviction score” that feeds into our portfolio construction framework.
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Value investing & earnings quality

The outperformance of stocks with high ratios of free-cash-flow to enterprise value could capture two sources of mispricing:

• The well documented value premium; and/or
• The accruals anomaly,[1] representing the degree to which accounting earnings are backed by cash flows

To further explore this question, we compared the returns from a strategy of investing in companies with good “earnings quality” – which we define as the ratio of enterprise-free-cash-flow to enterprise-accounting-profits – with the returns from the enterprise-free-cash-flow classification of value.

We find that the returns from investing on the basis of earnings quality are remarkably similar and remarkably correlated to the returns from investing on the basis of value as measured by enterprise-free-cash-flow. This could be interpreted in a number of ways:

• “Value” has been arbitraged away while the accruals anomaly has persisted; or
• The value and accruals anomalies are one in the same[2].

It is difficult to definitively answer this question but in our experience both explanations are valid in particular circumstances. With regard to earnings quality, management teams and boards are becoming ever increasingly creative about how they define profitability. Our favourite notorious measure is “pro-forma adjusted Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA)”. This measure usually and conveniently ignores capital expenditure, working capital requirements, restructuring costs, discontinued operations and asset impairments to name a few. It is often used to justify expensive acquisitions and even more cynically, used as a basis for management remuneration.

The bottom line is management teams can define profitability however they choose but can’t as easily hide from the realities of the cash flow statement. Eventually these realities come home to roost and when this happens stocks with low earnings quality tend to underperform. So long as investors place weight on measures such as “pro-forma adjusted EBITDA”, we think the accruals anomaly is likely to persist.

At the same time, we think it would be irresponsible to “pay-any-price” for companies with high earnings quality (or indeed high quality businesses in general) and this style of investing is prone to many of the behavioural biases that support excess returns from value investing in the first place.
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Are value strategies riskier than glamour strategies?

There are two schools of thought as to why value strategies have historically outperformed glamour or growth strategies. The first is value strategies are riskier than passive strategies. This is intuitively appealing when we consider the nature of value stocks. These companies are typically plagued with investor concerns, surrounded by popular pessimism and often have high levels of financial and operating leverage.

A brief look at the top 10 industrial stocks in the ASX ranked by free-cash-flow-yield highlights this point.

Different investors will perceive risk differently but for us the most crucial measure of risk is how particular portfolios perform in down markets. Figure 4 illustrates the performance of value strategies based on enterprise-free-cash-flow through a variety of market conditions. The point to note is that there is little difference in performance in up markets and down markets. If anything, the value portfolios perform better in more adverse market conditions.

Figures 3 and 4 highlight one of the challenges faced by many investors and their sponsors. The challenge is distinguishing between diversifiable risk (or company specific risk) and non-diversifiable risk (or systematic risk). By definition, company specific risk can be diversified away whereas systemic risk cannot. Myer &#; a department store &#; might appear to be a risky investment. However, investors should be only be concerned with how the stock performs within the context of a portfolio and how such a portfolio is likely to perform in a meaningfully down market.

Indeed, when we invest in businesses we place significant weight on understanding and quantifying downside valuation scenarios and their dependencies on uncontrollable external influences such as macroeconomic conditions. These are “systematic risks” that cannot be diversified away. This “margin-of-safety” concept is explicitly considered when we develop our “conviction scores” that combine with valuation to determine portfolio weights.

Concluding comments

The performance of value investing on the basis of free-cash-flow in an Australian context has been compelling and, in our view, represents a strong foundation for active stock selection. This key finding underpins Merlon’s investment philosophy which is built around the notion that companies undervalued on the basis of free-cash-flow and franking will outperform over time.

Any investment philosophy needs to be supported by an understanding of whya particular approach is likely to generate excess returns. In this paper we begin to explore this question. Consistent with our philosophy, we present findings that show a linkage between value investing on the basis of free-cash-flow and earnings quality. We then go on to dismiss the notion that value investing is “riskier” than passive alternatives.

In our third paper in this series to be released next quarter we will highlight a number of well documented behavioural biases that are empirically and anecdotally evident in the Australian market. We will also point to various elements of the Merlon investment process, structure and culture that are aimed at minimising our exposure to these biases.

Author: Hamish Carlisle, Analyst/Portfolio Manager

[1] See: “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?”, R Sloan &#; The Accounting Review

[2] See, for example: “Value-glamour and accruals mispricing: One anomaly or two?”, H Desai, S Rajgopal, M Venkatachalam &#; The Accounting Review,
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Value investing and growth investing are two different investing styles. Usually, value stocks present an opportunity to buy shares below their actual value, and growth stocks exhibit above-average revenue and earnings growth potential.

Wall Street likes to neatly categorize stocks as either growth stocks or value stocks. The truth is a bit more complicated since some stocks have elements of both value and growth. Nevertheless, there are important differences between growth and value stocks, and many investors prefer one style of investing over the other.

Image source: Getty Images.

Growth stocks

Growth companies prioritize going from small, up-and-coming businesses to leaders in their respective industries as quickly as possible. Early on, these types of companies tend to concentrate on building up their revenue, often at the cost of delaying profitability. After a period of time, growth companies start focusing more on maximizing profits.

As those key financial metrics grow, the perceived value of the company rises in the eyes of growth-minded investors. That can create a positive feedback loop. A rising stock price can boost a company's reputation, helping it win even more business opportunities.

Growth stocks tend to have relatively high valuations as measured by price-to-earnings or price-to-book value ratios. However, they also see faster growth in revenue and income than their peers.

Value stocks

Value stocks are publicly traded companies trading for relatively cheap valuations relative to their earnings and long-term growth potential.

Value stocks don't have flashy growth characteristics. Companies considered value stocks tend to have steady, predictable business models that generate modest gains in revenue and earnings over time. Sometimes you can find value stocks with companies that are in decline. Still, their stock price is so low that it understates the value of their future profit potential.

Which is better: growth or value?

Both growth stocks and value stocks offer lucrative investing opportunities to their shareholders. The best investment style for you depends largely on your personal financial goals and your investing preferences.

Growth stocks are more likely to be appealing if the following apply to you:

• You're not interested in current income from your portfolio. Most growth companies avoid paying significant dividends to their shareholders. That's because they prefer to use all available cash by reinvesting it directly into their business to generate faster growth.
• You're comfortable with big stock price moves. The price of a growth stock tends to be extremely sensitive to changes in future prospects for a company's business. When things go better than expected, growth stocks can soar in price. When they disappoint, higher-priced growth stocks can fall back to Earth just as quickly.
• You're confident you can pick out winners in emerging industries. You'll often find growth stocks in fast-moving areas of the economy such as technology. It's common for many different growth companies to compete against each other. You'll need to pick as many of the eventual winners in an industry as you can, while avoiding losers.
• You have plenty of time before you'll need your money back. Growth stocks can take a long time to realize their full potential, and they often suffer setbacks along the way. It's critical that you have a long enough time horizon to give the company a chance to grow.

Value stocks may look more attractive if you seek out these characteristics:

• You want current income from your portfolio. Many value stocks pay out substantial amounts of cash as dividendsto their shareholders. Because such businesses lack significant growth opportunities, they have to make their stock attractive in other ways. Paying out attractive dividend yields is one way to get investors to look at a stock.
• You prefer more stable stock prices. Value stocks don't tend to see very large movements in either direction. As long as their business conditions remain within predictable ranges, stock price volatility is usually low.
• You're confident you can avoid value traps. In many cases, stocks that look cheap are value traps, or cheap for a good reason. It could be that a company has lost its competitive edge, or it can't keep up with the pace of innovation. You'll have to be able to look past attractive valuations to see when a company's future business prospects are poor.
• You want a more immediate payoff from your investment. Value stocks don't turn things around overnight. However, if a company is successful in getting its business moving in the right direction, its stock price can rise quickly. The best value investors identify and buy shares of those stocks before other investors catch on.

Finally, when it comes to overall long-term performance, there's no clear-cut winner between growth and value stocks. When economic conditions are good, growth stocks on average modestly outperform value stocks. During more difficult economic times, value stocks tend to hold up better. Therefore, which group outperforms depends a lot on the specific time period you're considering.

Tracking growth and value indexes

These trends can be seen in growth and value indexes, which are benchmarks designed to track each group of stocks. The S&P Growth Index (NYSEMKT:SPYG) draws from the roughly stocks in the S&P It selects the stocks that have the best three-year growth in revenue and earnings per share with the strongest upward momentum in price. The S&P Value Index (NYSEMKT:SPYV) selects stocks with the best valuations based on several major stock valuation metrics.

There's no reason you can't own both growth stocks and value stocks. Each group has its own attractive qualities. Having diversified exposureto both in your portfolio can give you the best of both worlds.

It's also fine if you identify more with one investing style than the other. Once you settle on your goals for your investments, you'll have a better sense of whether you're a growth investor, a value investor, or a bit of both.

We continue an interview with Zeke Ashton, Matthew Richey, and Bryan Adkins of savvy value investing hedge fund Centaur Capital.

Emil Lee: It seems your investment thesis for both long and short ideas is to find "obvious ideas." To buy shares in high-quality companies at low prices, investors must often overlook a "stigma" -- such as LabCorp's reputation for being mature and stodgy (I covered this company as an analyst). Best of value investing part 2 you give us your ideas on what "stigmas" should be overlooked and which ones shouldn't? How do you avoid "value traps"?

Zeke Ashton: To the extent that we can find simple, easy-to-analyze businesses that are obviously very cheap, we naturally prefer those. In investing, you don't get extra points for "degree of difficulty" -- this is why Warren Buffett talks about looking around for 1-foot bars to step over rather than trying to learn how to jump over 7-foot bars. Unfortunately, after the run-up we've seen in small-cap stocks over the past five or six years, the market hasn't offered a lot of simple, high-quality businesses trading at less than 10 times free cash flow for a while, best of value investing part 2, so we've had to work a little harder to find good ideas.

Matthew Richey: As for "value traps," it's probably helpful to define the term. I've seen certain stocks labeled as value traps just because they've traded at low multiples for an extended period of time. That's not necessarily a value trap. For instance, back in we owned one so-called value trap, Lone Star Steakhouse, which worked out very well for us, rising from $18 to $27 within two years best of value investing part 2 paying large dividends all the way. A true value trap is a stock that trades at a low multiple to earnings, free cash flow, book value, or some other statistical metric -- but where that low multiple is not indicative of being undervalued. Typically, the low multiple is justified because the company's current earnings power is at risk of being impaired, best of value investing part 2 else because the business is prone to becoming obsolete within the next decade.

The best way to avoid value traps is to never buy a stock just because it appears cheap on some statistical multiple. Back in andthere were a ton of good businesses at low multiples -- and most of them were genuine bargains. But today, a low-multiple stock is far more likely to be a subpar business facing some nasty risk factors -- i.e., a value trap. Value investing, best of value investing part 2, contrary to how it's often portrayed by financial academics, does not merely equate to buying low-multiple stocks. Intelligent value investing requires thinking through all forward-looking assumptions, and thereby figuring out what a business is worth. Best of value investing part 2 businesses justify low multiples; some justify high multiples. It all just depends on the nature of the business -- competitive advantages, growth prospects, [and the like]. It's by this process of independent thinking and testing our assumptions that we're able to weed out value traps, best of value investing part 2, while also occasionally finding gems that carry an unjustified stigma.

ZA: LabCorp is actually a very simple business, best of value investing part 2, and was one that we felt was very predictable. From a valuation standpoint, we were able to use free cash flow and basic free cash flow multiples as a starting point on the valuation. At the time of our original purchase of LabCorp back in lateI don't think it was cheap because of any stigma so much, but rather it was simply not fully appreciated for the outstanding qualities it possessed. It was an excellent business but an "in between" stock. It was a growing business, but not growing fast enough for the growth-type investors. It was very reasonably priced, but not cheap enough for the hardcore value investor. The company's financials were somewhat distorted by a history of acquisitions that inflated the P/E ratio, turning off investors attracted by that metric. It wasn't in the S&P at the time we purchased it, either.

In any event, over the past couple of years, LabCorp has been such a stellar business, and the best of value investing part 2 has delivered excellent earnings and cash flow and bought back a ton of stock. Also, the company was added to the S&Pand I think people just woke up to the fact that LabCorp was a very good business trading at a big discount to the S&P Even now the company isn't overpriced by any means. In short, any good company that becomes undervalued gets there either because investors don't recognize it as a good business, or because a number of investors don't want to own it right then [because of] some recent negative news.

It's part of our job to try to figure out what the negative argument on any idea might be, and to try to determine if the negative thesis has merit. Sometimes, we simply can't figure out why a stock is cheap, and in those cases, we simply try to cover all the bases in our research. We've learned over time to trust our own judgment when we can't find any valid reason or identify a stigma that might explain why a given stock might be cheap.

EL: Please provide a "cradle to grave" description of one of your successful investments.

MR: AllianceBernstein [formerly Alliance Capital] has been a longtime resident in our portfolio, off and on, for much of the past four years. We found the stock back inwhen it fell sharply amidst the mutual fund scandal and industrywide investigations by Eliot Spitzer. In lateAB traded for around $30 per share, with a dividend yield of 6% and a multiple of less than 10 [times] structural FCF. One of the reasons AB remained cheap for so long is because it has an unusual corporate structure. The publicly traded entity is a limited partnership which owns roughly one-third of the parent company. This structure requires that investors take a "look through" approach to the overall parent company [the AllianceBernstein operating partnership] in order to understand the true worth of the publicly-traded share [AllianceBernstein Holdings L.P.].

Fortunately, we were inclined to do the work because we love asset managers -- an industry we know a thing or two about. The asset-management economic model has no inventory or receivables risk, plus it has bitcoin investors forum definition potential for economies of scale as assets under management grow. Particular to AB, we really liked the acquisition of Sanford Bernstein, which brought a value-investing philosophy to a company that previously had been geared primarily toward growth investing.

The stock was a good performer in but really took off in late thanks to rapid asset inflows into its value and international investment products. By earlywe had the opportunity to sell at best of value investing part 2 over $60, which was where we pegged conservative fair value, based on a DCF model and conservative growth assumptions. After we sold, the stock went as high as $72, but within six months it was back below $ By that time, we had the benefit of two more quarters of financial results, which showed that AB's growth in profits and FCF had been much stronger than we'd previously anticipated. As such, we saw fit to increase our fair value estimate to the low $70s.

With AB just over $57, best of value investing part 2, in Augustthe stock was priced at around 80% of our new fair value estimate, making it a buy once again. As the stock market turned higher in fallso too did AB and we quickly got our chance to sell when the stock got north of $ Once again, we were probably overly conservative in our assumptions, as AB has gone to much higher levels (above $80 of late). But we were satisfied with our outcome, and we'll continue to follow the AB story and look to buy it again if it falls back to undervalued levels.

EL: Please provide a "cradle to grave" description for one of your unsuccessful investments.

ZA: Bandag is a stock that we had originally purchased back inwhen we saw it as a deeply undervalued, cash-flow producing business at very low multiples to cash flow. The company was the market share leader in re-treading equipment for tires and owned patents on the method, in addition to selling the equipment and rubber for the actual re-treading. Simple ways to make money as a teenager company had a long history of cash generation, increasing dividends, and best of value investing part 2 share buybacks. In addition, at that time it was in the process of divesting a relatively unprofitable chain of retail tire stores that ultimately freed up a lot more cash and highlighted the true profitability of the underlying business. We later sold at a nice profit.

About a year later, in latethe stock fell way back and we purchased Bandag again. Unfortunately, this time around the company was suffering from significant inroads being made anno 1800 wie geld verdienen cheaper new tires from Asia, while input costs were also increasing. These two factors were rapidly squeezing Bandag's margins. Bandag was compensating for this by directing its cash flow to a new chain of truck lubrication and service stations, best of value investing part 2, which at the time we thought might be a good idea. Unfortunately, it became apparent to us after several quarters that this initiative was never going to have the returns once generated by the core business, and that the core business, while likely to survive, was likely to be far less profitable going forward as globalization took its toll. We sold our shares at about a best of value investing part 2 loss from our original purchase price the second time around in order to buy some other things that looked better to us at the time.

In a final ironic twist, Bandag later announced it would be bought by Bridgestone at a price that would have represented a very nice return on our original stock price. There are a couple of lessons in this: First, in our modern world the competitive moat around a business can deteriorate rapidly. Second, in looking back at our research on the company, we actually believe that selling was the right thing to do, and that there was no way to have seen a buyout coming because Bandag had been a family-controlled company for decades and there was no indication that was going to change. We see their having to sell that business as a confirmation of weakness, not strength. That's not to say we would've minded having a good outcome for our troubles instead of a bad one.

In summary, we think our original decision to buy Bandag was good, as was our decision to sell. The second purchase of Bandag, even though it was only two years later, was flawed -- Bandag's fundamentals had deteriorated, and the stock had become a great example of the "value trap" that Matthew described earlier. Of course, had we taken longer to realize our mistake and gotten the benefit of the favorable acquisition price, we might still have best of value investing part 2 a good outcome from a poor decision.

Check back later
Again, great insight from Centaur: Sometimes value is right under your nose, as with LabCorp, and sometimes you have to look from a different angle, as with AllianceBernstein. Check back again to learn more about Centaur's investing strategies, as well as a stock they're attracted to now.

For related Foolishness:

LabCorp of America is a Stock Advisor recommendation and AllianceBernstein is recommended in Income Investor. Philip Durell looks for bargains for Inside Value subscribers. Try any one of our investing services free for 30 days.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above, and he appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.

The best thing about investing strategies is that they’re flexible. If you choose one and it doesn’t suit your risk tolerance or schedule, you can certainly make changes. But be forewarned: doing so can be expensive. Every purchase carries a fee. More importantly, selling assets can create a realized capital gain. These gains are taxable and therefore, expensive.

Here, we best of value investing part 2 at four common investing strategies that suit most investors. By taking the time to understand the characteristics of each, you will be in a better position to choose one that’s right for you over the long-term without the need to incur the expense of changing course.

Take Some Notes

Before you begin to research your investment strategy, it's important to gather some basic information about your financial situation. Ask yourself these key questions:

• What is your current financial situation?
• What is your cost of living including monthly expenses and debts?
• How much can you afford to invest—both initially and on an on-going basis?

Even though you don't need a lot of money to get started, you shouldn't get start if you can't afford to do so. If you have a lot of debts or other obligations, consider the impact investing will have on your situation before you start putting money aside.

Next, set out your goals. Everyone has different needs, so you should determine what yours are. Are you intending best of value investing part 2 save for retirement? Are you looking to make big purchases like a home or car in the future? Or are best of value investing part 2 saving for your or your children's education? This will help you narrow down a strategy.

Figure out what your risk tolerance is. This is normally determined by several key factors including your age, best of value investing part 2, income, and how long you have until you retire. Technically, the younger you are, best of value investing part 2, the more risk you can take on. More risk means higher returns, while lower risk means the gains won't be realized as quickly. But keep in mind, high-risk investments also mean there's a greater potential for losses as well.

Finally, learn the basics. It's a good idea to have a basic understanding of what you're getting into so you're not investing blindly. Ask questions. And read on to learn about some of the key strategies out there.

Strategy 1: Value Investing

Value investors are bargain shoppers. They seek stocks they believe are undervalued. They look for stocks with prices they believe don’t fully reflect the intrinsic value of the security. Value investing is predicated, in part, on the idea that some degree of irrationality exists in the market. This irrationality, in theory, presents opportunities to get a stock at a discounted price and make money from it.

It’s not necessary for value investors to comb through volumes of financial data to find deals. Thousands of value mutual funds give investors the chance to own a basket of stocks thought to be undervalued. The Russell Value Index, for example, best of value investing part 2, is a popular benchmark for value investors and several mutual funds mimic this index.

As discussed above, investors can change strategies anytime but doing so—especially as a value investor—can be costly. Despite this, many investors give up on the strategy after a few poor-performing years. InWall Street Journal reporter Jason Zweig explained, “Over the decade ended December 31, value funds specializing in large stocks returned an average of % annually. But the typical investor in those funds earned just % annually.” Why did this happen? Because too many investors decided to pull their money out and run. The lesson here is that in order to make value investing work, you must play the long game.

Warren Buffet: The Ultimate Value Investor

But if you are a true value investor, you don't need anyone to convince you need to stay in it for the long run because this strategy is designed around the idea that one should buy businesses—not stocks. That means the investor must consider the big picture, not a temporary knockout performance. People often cite legendary investor Warren Buffet as the epitome of a value investor. He does his homework—sometimes for years. But when he’s ready, he goes all in and is committed for the long-term.

Consider Buffett’s words when he made a substantial investment in the airline industry. He explained that airlines "had a bad first century." Then he said, "And they got a bad century out of the way, I hope." This thinking exemplifies much of the value investing approach. Choices are based on decades of trends and with decades of future performance in mind.

Value Investing Tools

For those who don’t have time to perform exhaustive research, the price-earnings ratio (P/E) has become the primary tool for quickly identifying undervalued or cheap stocks. This is a single number that comes from dividing a stock’s share price by its earnings per share (EPS). A lower P/E ratio signifies you’re paying less per $1 of current earnings. Value investors seek companies with a low P/E ratio.

While using the P/E ratio is a good start, some experts warn this measurement alone is not enough to make the strategy work. Research published in the Financial Analysts Journal determined that “Quantitative investment strategies based on such ratios are not good substitutes for value-investing strategies that use a comprehensive approach in identifying underpriced securities.”  The reason, according to their work, is that make money song are often lured by low P/E ratio stocks based best of value investing part 2 temporarily inflated accounting numbers. These low figures are, in many instances, the result of a falsely high earnings figure (the denominator). When real earnings are reported (not just forecasted) they’re often lower. This results in a “reversion to the mean.” The P/E ratio goes up and the value the investor pursued is gone.

If using the P/E ratio alone is flawed, what should an investor do to find true value stocks? The researchers suggest, “Quantitative approaches to detecting these distortions—such as combining formulaic value with momentum, quality and profitability measures—can help in avoiding these ‘value traps.’”

What's the Message?

The message here is that value investing can work so long as the investor is in it for the long-term and is prepared to apply some serious effort and research to their stock selection. Those willing to put the work in and stick around stand to gain. One study best of value investing part 2 Dodge & Cox determined that value strategies nearly always outperform growth strategies “over horizons of a decade or more.” The study goes on to explain that value strategies have underperformed growth strategies for a year period in just three periods over the last 90 years. Those periods were the Great Depression (/40), the Technology Stock Bubble () and the period /

Strategy 2: Growth Investing

Rather than look for low-cost deals, growth investors want investments that offer strong upside potential when it comes to the future earnings of stocks. It could be said that a growth investor is often looking for the “next big thing.” Growth investing, however, is not a reckless embrace of speculative investing. Rather, it involves evaluating a stock’s current health as well as its potential to grow.

A growth investor considers the prospects of the industry in which the stock thrives, best of value investing part 2. You may ask, for example, if there’s a future for electric vehicles before investing in Tesla. Or, you may wonder if A.I. will become a fixture of everyday living best of value investing part 2 investing in a technology company. There must be evidence of a widespread and robust appetite for the company's services or products if it’s going to grow. Investors can answer this question by looking at a company's recent history. Simply put: A growth stock should be growing. The company should have a consistent trend of strong earnings and revenue signifying a capacity to deliver on growth expectations.

A drawback to growth investing is a lack of dividends. If a company is in growth mode, it often needs capital to sustain its expansion. This doesn’t leave much (or any) cash left for dividend payments. Moreover, with faster earnings growth comes higher valuations which are, for most investors, a higher risk proposition.

Does Growth Investing Work?

As the research above indicates, value investing tends to outperform growth investing over the long-term. These findings don’t mean a growth investor can't profit from the strategy, it merely means a growth strategy doesn’t usually generate the level of returns seen with value investing. But according to a study best of value investing part 2 New York University’s Stern School of Business, “While growth investing underperforms value investing, especially over long time periods, it is also true that there are sub-periods, where growth investing dominates.” The challenge, of course, is determining when these “sub-periods” will occur. 

Interestingly, determining the periods when a growth strategy is poised to perform may mean looking at the gross domestic product (GDP). Take the time between andwhen a growth strategy beat a value strategy in seven years (, and ). During five of these years, the GDP growth rate was below 2%. Meanwhile, a value strategy won in nine years, best of value investing part 2, and in seven of those years, the GDP was above 2%. Therefore, it stands to reason that a growth strategy may be more successful during periods of decreasing GDP.

Some growth investing style detractors warn that “growth at any price” is a dangerous approach. Such a drive gave rise to the tech bubble which vaporized millions of portfolios. “Over the past decade, the average growth stock has returned % vs. just 89% for value,” according to Money magazine’s Investor’s Guide 

Growth Investing Variables

While there is no definitive list of hard metrics to guide a growth strategy, there are a few factors an investor should consider. Research from Merrill Best of value investing part 2, for example, found that growth stocks outperform during periods of falling interest rates. It's important to keep in mind that at the first sign of a downturn in the economy, growth stocks are often the first to get hit.

Growth investors also need to carefully consider the management prowess of a business’s executive team. Achieving growth is among the most difficult challenges for a firm. Therefore, a stellar leadership team is required. Investors must watch how the team performs and the means by which it achieves growth. Growth is of little value if it’s achieved with heavy borrowing. At the same time, investors should evaluate the competition. A company may enjoy stellar growth, but if its primary product is easily replicated, the long-term prospects are dim.

GoPro is a prime example of this phenomenon. The once high-flying stock has seen regular annual revenue declines since “In the months following best of value investing part 2 debut, shares more than tripled the IPO price of $24 to as much as $87,” the Wall Street Journal reported. The stock has traded well below its IPO price. Much of this demise is attributed to the easily replicated design. After all, GoPro is, at its core, a small camera in a box. The rising popularity and quality of smartphone cameras offer a cheap alternative to paying $ to $ for what is essentially a one-function piece of equipment. Moreover, the company has been unsuccessful at designing and releasing new products which is a necessary step to sustaining growth—something growth investors must consider.

Strategy 3: Momentum Investing

Momentum investors ride the wave. They believe winners keep winning and losers keep losing. They look to buy stocks experiencing an uptrend. Because they believe losers continue to drop, they may choose to short-sell those securities. But short-selling is an exceedingly risky practice. More on that later.

Think of momentum investors as technical analysts. This means they use a strictly data-driven approach to trading and look for patterns in stock prices to guide their purchasing decisions. In essence, best of value investing part 2, momentum investors act in defiance of the efficient-market hypothesis (EMH). This hypothesis states that asset prices fully reflect all information available to the public. It’s difficult to believe this statement and be a momentum investor given that the strategy seeks to capitalize on undervalued and overvalued equities.

Does it Work?

As is the case with so many other investing styles, the answer is complicated. Let’s take a closer look.

Rob Arnott, chair, and founder of Research Affiliates researched this question and this is what he found. “No U.S. mutual fund with ‘momentum’ in its name has, since its inception, outperformed their benchmark net of fees and expenses.”

Interestingly, Arnott’s research also showed that simulated portfolios that put a theoretical momentum investing strategy to work actually “add remarkable value, in most time periods and in most asset classes.” However, when used in a real-world scenario, best of value investing part 2, the results are poor. Why? In two words: trading costs. All of that buying and selling stirs up a lot of brokerage and commission fees.

Traders who adhere to a momentum strategy need to be at the switch, and ready to buy and sell at all times. Profits build over months, not years. This is in contrast to simple buy-and-hold strategies that take a set it-and-forget it approach, best of value investing part 2.

For those who take lunch breaks or simply don’t have an interest in watching the market every day, there are momentum style exchange-traded funds (ETFs). These shares give an investor access to a basket of stocks deemed to be characteristic of momentum securities.

The Appeal of Momentum Investing

Despite some of its shortcomings, momentum investing has its appeal, best of value investing part 2. Consider, for example, that “The MSCI World Momentum Index has averaged annual gains of % over the past two decades, almost twice that of the broader benchmark.” This return probably doesn’t account for trading costs and the time required for execution.

Recent research finds it may be possible best of value investing part 2 actively trade a momentum strategy without the need for full-time trading and research. Using U.S. data from the New York Stock Exchange (NYSE) between anda study found that a simplified momentum strategy outperformed the benchmark even after accounting for transaction costs. Moreover, a minimum investment of $5, was enough to realize the benefits.

The same research found that comparing this basic strategy to one of best of value investing part 2 frequent, smaller trades showed the latter outperformed it, but only to a degree. Sooner or later the trading costs of a rapid-fire approach eroded the returns, best of value investing part 2. Better still, best of value investing part 2, the researchers determined that “the optimal momentum trading frequency ranges from bi-yearly to monthly”—a surprisingly reasonable pace.

Shorting

As mentioned earlier, aggressive momentum traders may also use short selling as a way to boost their returns. This technique allows an investor to profit from a drop in an asset’s price. For example, the short seller—believing a security will fall in price—borrows 50 shares totaling $ Next, best of value investing part 2, the short seller immediately sells those shares on the market for $ and then waits for the asset to drop. When it does, they repurchase the 50 shares (so they can be returned to the lender) at, let’s say, $ Therefore, the short seller gained $ on the initial sale, best of value investing part 2, then spent $25 to get the shares back for a gain of $

The problem with this strategy is that there is an unlimited downside risk. In normal investing, the downside risk is the total value of your investment. If you invest $, the most you can lose is $ However, with short selling, your maximum possible loss is limitless. In the scenario above, for example, you borrow 50 shares and sell them for $ But perhaps the stock doesn’t drop as expected. Instead, it goes up.

The 50 shares are worth $, then $ and so on. Sooner or later the short seller must repurchase the shares to return them to the lender. If the share price keeps increasing, this will be an expensive proposition.

The Lesson?

A momentum strategy may be profitable, but not if it comes at the limitless downside risk associated with short selling.

Strategy 4: Dollar-Cost Averaging

Dollar-cost averaging (DCA) is the practice of making regular investments in the market over time, best of value investing part 2, and is not mutually exclusive to the other methods described above. Rather, it is a means of executing whatever strategy you chose. With DCA, you may choose to put $ in an investment account every month. This disciplined approach becomes particularly powerful when you use automated features that invest for you. It’s easy to commit to a plan when the process requires almost no oversight.

The benefit of the DCA strategy is that it avoids the painful and ill-fated strategy of market timing. Even seasoned investors occasionally feel the temptation to buy when they think prices are low only to discover, to their dismay, they have a longer way to drop.

When investments happen in regular increments, the investor captures prices at all levels, from high to low. These periodic investments effectively lower the average per share cost of the purchases. Putting DCA to work means deciding on three parameters:

• The total sum to be invested
• The window of time during which the investments will be made
• The frequency of purchases

A Wise Choice

Dollar-cost averaging is a wise choice for most investors. It keeps you committed to saving while reducing the level of risk and the effects of volatility. But for those in the position to invest a lump sum, DCA may not be the best approach.

According to a Vanguard study, best of value investing part 2, “On average, we find that an LSI (lump sum investment) approach has outperformed a DCA approach approximately two-thirds of the time, even when results are adjusted for the higher volatility of a stock/bond portfolio versus cash investments.”

But most investors are not in a position to make a single, large investment. Therefore, DCA is appropriate for most. Moreover, a DCA approach is an effective countermeasure to the cognitive bias inherent to humans. New and experienced investors alike are susceptible to hard-wired flaws in judgment. Loss aversion bias, for example, causes us to view the gain or loss of an amount of money asymmetrically. Additionally, confirmation bias leads us to focus on and remember information that confirms our long-held beliefs while ignoring contradictory information that may be important.

Dollar-cost averaging circumvents these common problems by removing human frailties from the equation. Regular, automated investments prevent spontaneous, illogical behavior. The same Vanguard study concluded, “If the investor is best of value investing part 2 concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use.”

Once You've Identified Your Strategy

So you've narrowed down a strategy. Great! But there are still a few things you'll need to do before you make the first deposit into your investment account.

First, figure out how much money you need to cover your investments. That includes how much you can deposit at first as well as how much you can continue to invest going forward.

You'll then need to decide the best way for you to invest. Do you best of value investing part 2 to go to a traditional financial advisor or broker, or is a passive, worry-free approach more appropriate for you? If you choose the latter, consider signing up with a robo-advisor. This will help you figure out the cost of investing from management fees to commissions you'll need to pay your broker or advisor. Another thing to keep in mind: Don't turn away employer-sponsored ks — that's a great way to start investing. Most companies allow you to invest part of your paycheck and tuck it away tax-free and many will match your contributions. You won't even notice because you don't have to do a thing.

Consider your investment vehicles. Remember that it doesn't help to keep your eggs in one basket, best of value investing part 2, so make sure you spread your money around to different investment vehicles by diversifying—stocks, bonds, mutual funds, ETFs. If you're someone who is socially conscious, you may consider responsible investing. Now is the time to figure out what you want your investment portfolio to be made of and what it will look like, best of value investing part 2.

Investing is a roller coaster, so keep your emotions at bay. It may seem amazing when your investments are making money, but when they take a loss, best of value investing part 2, it may be difficult to handle. That's why it's important to take a step back, take your emotions out of the equation and review your investments with your advisor on a regular basis to make sure they're on track.

The Bottom Line

The decision to choose a strategy is more important than the strategy itself. Indeed, any of these strategies can generate a significant return as long as the investor makes a choice best of value investing part 2 commits to it. The reason it is important to choose is that the sooner you start, the greater the effects of compounding.

Remember, don’t focus exclusively on annual returns when choosing a strategy. Engage the approach that suits your schedule and risk tolerance. Ignoring these aspects can lead to a high abandon rate and frequently changed strategies. And, as discussed above, numerous changes generate costs that eat away at your annual rate of return.

It&#x;s the perennial question among stock investors: which is better &#x; growth investing or value investing? Recently, there&#x;s been little contest. Growth stocks, such as Amazon and Apple, best of value investing part 2, have handily outperformed value names. But it&#x;s not always that way, and many investors think value will once again have its day, though they have been waiting on that day for quite some time.

Here&#x;s what investors say about growth and value investing, and when we might see value investing begin to outperform again.

Differences between growth investing and value investing

Many see the distinction between growth and value as somewhat arbitrary, but it&#x;s useful to lay out what might differ between the two approaches, even if it seems a bit like a stereotype.

Growth investing

Growth investors look for $ stocks that could be worth $ viel geld verdienen schweiz a few years if the company continues to grow quickly. As such, the success of their investment relies on the expansion of the company and the market continuing to price growth stocks at a premium valuation, as measured by a P/E ratio maybe, in later years if the company continues to succeed.

Growth stocks are sometimes also called momentum stocks, because their strong upward rise leads to more and more investors piling into them. Sometimes that movement occurs regardless of the company&#x;s fundamentals, as investors build pie in the sky expectations around the company. When those expectations aren&#x;t realized as quickly as some investors expect, a growth stock can plunge, though it may later rise with renewed optimism.

Value investing

In contrast, value investors look for $50 stocks that are actually worth $ today, not in a few years, if the company continues its business plan. These investors are typically buying stocks that are out of favor now and therefore have a low valuation. They&#x;re betting on the market&#x;s opinion becoming more favorable, pushing up the stock price.

Value investing is based on the premise that paying less for a set of future cash flows is associated with a higher expected return, says Wes Crill, best of value investing part 2, head of investment strategists at Dimensional Fund Advisors in Austin, Texas. That&#x;s one of the most fundamental tenets of investing.

Many of America&#x;s most famous investors are value investors, including Warren Buffett, Charlie Munger and Ben Graham, among many others. Still, plenty of very wealthy individuals own growth stocks, including Amazon&#x;s founder Jeff Bezos and hedge fund billionaire Bill Ackman, and even Buffett has shifted his approach to become more growth-oriented these days.

Growth investing and value investing differ in other key ways, too, as detailed in the table below.

But the difference between growth and value investors can sometimes be artificial, as many investors agree. There are times when growth stocks are undervalued and there are plenty of value stocks that grow. Regardless of their style, investors are trying to buy a stock that&#x;s worth more in the future than it is today. And both value companies and growth companies tend to expand at least a little over time and often significantly, making them some of the best long-term investments to buy. So the definitions of the terms are a bit slippery.

Typical investing wisdom might say that when the markets are greedy, growth investors win and when they are fearful, value investors win, says Blair Silverberg, CEO of Hum Capital, a funding company for early-stage firms based in New York City.

The s are a little different, Silverberg says. There are best of value investing part 2 tailwinds best of value investing part 2 technology companies and you can actually find value by buying great companies at fair prices.

And sometimes the difference between the two investing styles may be largely psychological.

The market sometimes overlooks the earnings growth potential in a company just because it has been bucketed as a value stock, says Nathan Rex, chief investment officer at Eigenvector Capital in Stamford, Connecticut.

Which is better: growth investing or value investing?

The question of which investing style is better depends on many best of value investing part 2, since each style can perform better in different economic climates. Growth stocks may do better when interest rates are low and expected to stay low, but many investors shift to value stocks as rates rise. Growth stocks have had a stronger run recently, but value stocks have a good long-term record.

Growth stocks continue to outperform

Currently growth stocks have been having a nice go, with the last decade spent running up on the backs of large tech companies with massive opportunities, best of value investing part 2. Tech stocks such as Meta Platforms, Alphabet, Amazon, Apple and Netflix &#x; once named FAANG stocks (when Alphabet used to be called Google and Meta Platforms was Facebook) &#x; now dominate the market and comprise a huge portion of key indexes such as the Standard & Poor&#x;s As best of value investing part 2 trillion-dollar player, Microsoft is also added to this mix.

In the five years endinglarge-cap growth outperformed large-cap value by a cumulative 30 percent, says Ryan Johnson, CFA, director of portfolio management and research at Buckingham Advisors in Dayton, Ohio. Still, the annualized return of value was respectable, at over 9 percent.

So what&#x;s driving growth stocks?

Investors have become so fearful of short-term events and a low-growth economy that they are willing to pay a higher premium for growth in future years, says Rex.

The FAANG stocks, for example, all traded over 24 times earnings in late In contrast, the S&P &#x;s historical P/E ratio is closer to 16 times earnings.

The driver for growth vs. value over the last decade has been the market&#x;s grasp for anything that could demonstrate the ability to increase earnings in a low-growth, disinflationary environment, says Jeff Weniger, head of equity strategy at WisdomTree Investments in Chicago.

Weniger points to tech and communications services stocks as winners on the growth side, while gesturing to energy and financials as stocks that struggle in this environment, two sectors that tend to populate value indexes. The pandemic exacerbated best of value investing part 2 disparity, as tech stocks may have thrived while old-line companies were hit harder, he says.

The interest rate environment has been terrible for traditional banks, says Norm Conley, CEO and CIO at JAG Capital Management in the St. Louis area. While financials are cheap on some measures, their earnings power has been crimped severely by a flatter, lower yield curve, and the regulatory environment for banks has been anything but supportive since the Great Financial Best of value investing part 2 notes that many value indices are heavily-weighted to &#x;old economy,&#x; asset-intensive companies, during a period of massive technological growth and disruption.

Value investing tends to outperform over the long term

While growth stocks might win the short-term battle, value stocks are winning the long-term war, suggests Dr. Robert Johnson, finance professor at Creighton University and co-author of the book Strategic Value Investing.

From throughaccording to the data compiled by Nobel Prize laureate Eugene Fama and Dartmouth professor Kenneth French, over rolling year time periods, best of value investing part 2, value stocks have outperformed growth stocks 93 percent of the time, he says.

But over a shorter period, value may outperform at a lower percentage. Johnson cites the same research showing that in annual periods value outperformed just 62 percent of the time.

But that&#x;s not to say that value stocks as a whole will be winners when the market turns. It&#x;s important to distinguish value stocks that have permanent problems with those that may be suffering temporary setbacks or those the market has soured on for best of value investing part 2 time being.

Value investors have best of value investing part 2 run the risk of plowing capital into stocks that are cheap for a reason and ultimately continue to underperform, says Conley.

Such stocks are called value traps, but the same phenomenon exists with growth stocks, and investors who buy into highly valued growth names may get burned, if the companies are unable to maintain the rapid expansion that Wall Street demands.

Both value and growth investors run the risk of investing capital at prices that, in the fullness of time, will prove to have been too high, says Conley.

When will value outperform growth again?

The question that has been on the minds of many investors is when value stocks will outshine growth stocks. The short answer is, no one knows. The long answer is also, no one knows. But they do know eventually the market will again favor value stocks. Experts point to a few factors to consider when thinking about how value again becomes the more favored approach.

One sign to watch out for: inflation, best of value investing part 2. Weniger says that inflation helps value stocks more than it does growth stocks. Inflation reached its highest level in 40 years in early

Some traditional value sectors have performed well of late, as rising energy prices fueled inflation and increased investors&#x; expectations for higher interest rates. Those rises boosted energy and financial names inas investors priced in higher profits at these companies.

A favorable change in the near-term outlook would remove a great deal of the fear and pessimism that are currently holding value stocks back, says Rex. With such a change value stocks, which are growing earnings more quickly than growth stocks, will begin to outperform.

And value stocks are exactly where financial experts questioned in Bankrate&#x;s fourth-quarter survey expect to see outperformance through December

When, not if, U.S. large-cap tech falls out of favor, value&#x;s relative performance will improve, says Johnson of Best of value investing part 2 Advisors.

Many investors point to long-term studies showing that eventually the market does re-rate value stocks.

Our research shows that value investing continues to be a reliable way for investors to increase expected returns going forward, says Crill. He suggests that the longer you stay invested, the more likely value is to outperform, since history tells us value can show up in bunches.

And a plain old correction in stocks or a bear market may return value stocks to favor. With lower expectations built into their prices, value stocks often don&#x;t suffer the kind of downturn that higher-valued stocks do when the market sells off.

Bull market leaders are often bear market laggards, so it could be that the market hitting a rough patch is what causes beleaguered value stocks to outperform, much as they did from towhen that era&#x;s go-go stocks came back to earth, says Weniger.

In fact, that time may have already arrived. In earlystocks declined and fell into correction territory as investor concerns grew about the prospects of higher interest rates and the Russia-Ukraine conflict. Through March 3,best of value investing part 2, the Vanguard Russell Value ETF (VONV) has declined percent so far this year, while the iShares Russell Growth ETF (IWF) has fallen by percent. The ARK Innovation ETF (ARKK), which holds many once high-flying growth stocks, has fallen by percent in and nearly 50 percent over the past 12 months.

Bottom line

The old debate of growth vs. value will live on, but the empirical evidence suggests that value stocks outperform over time, even if growth stocks steal the daily headlines. If they&#x;re buying individual stocks, investors should stick to fundamental investing principles or otherwise consider buying a solid index fund that takes a lot of the risk out of stocks.

Learn more:

While the long term returns from “value investing” are strong and time consuming ways to make money documented, the approach has struggled over the past decade prompting many investors to question its merits.

This paper represents the second of what will now be a three part series discussing value investing from an Australian perspective. In the first paper we concluded that value investing on the basis of free-cash-flow has performed well through a number of market cycles and has displayed low levels of volatility when compared to traditional classifications of value such as earnings, best of value investing part 2, book value and dividends.

In this second paper, we begin to explore the question of why value strategies based on free-cash-flow outperform the broader market. Consistent with our philosophy, we present findings that show a linkage between value investing on the basis of free-cash-flow and earnings quality. We then go on to dismiss the notion that value investing is “riskier” than passive alternatives.
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Why do stocks with high free-cash-flow-yields tend to outperform?

The performance of value investing on the basis of free-cash-flow in an Australian context has been compelling and, in our view, represents a strong foundation for active stock selection. This key finding underpins Merlon’s investment philosophy which is built around the notion that companies undervalued on the basis of free cash flow and best of value investing part 2 will outperform over time.

A second key tenant of Merlon’s investment philosophy is that markets are mostly efficient. We don’t believe that value stocks outperform simply because they are “cheap” but rather because there are misperceptions in the market about their risk profiles and their growth outlooks.

We are focused on identifying and understanding potential misperceptions in the best of value investing part 2. To be a good investment, market concerns need to be priced in or deemed invalid. We incorporate these aspects with a “conviction score” that feeds into our portfolio construction framework.
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Value investing & earnings quality

The outperformance of stocks with high ratios of free-cash-flow to enterprise value could capture two sources of mispricing:

• The well documented value premium; and/or
• The accruals anomaly,[1] representing the degree to which accounting earnings are backed by cash flows

To further explore this question, we compared the returns from a strategy of investing in companies with good “earnings quality” – which we define as the ratio of enterprise-free-cash-flow to enterprise-accounting-profits – with the returns from the enterprise-free-cash-flow classification of value.

We find that the returns from investing on the basis of earnings quality are remarkably similar and remarkably correlated to the returns from investing on the basis of value as measured by enterprise-free-cash-flow. This could be interpreted in a number of ways:

• “Value” has been arbitraged away while the accruals anomaly has persisted; or
• The value and accruals anomalies are one in the same[2].

It is difficult to definitively answer this question but in our experience both explanations are valid in particular circumstances, best of value investing part 2. With regard to earnings quality, management teams best of value investing part 2 boards are becoming ever increasingly creative about how they define profitability. Our favourite notorious measure is “pro-forma adjusted Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA)”. This measure usually and conveniently ignores capital expenditure, working capital requirements, restructuring costs, discontinued operations and asset impairments to best of value investing part 2 a few. It is often used to justify expensive acquisitions and even more cynically, used as a basis for management remuneration.

The bottom line is management teams can define profitability however they choose but can’t as easily hide from the realities of the cash flow statement, best of value investing part 2. Eventually these realities come home to roost and when this happens stocks with low earnings quality tend to underperform. So long as investors place weight on measures such as “pro-forma adjusted EBITDA”, we think the accruals anomaly is likely to persist.

At the same time, we think it would be irresponsible to “pay-any-price” how to invest in gold bonds sbi companies with high earnings quality (or indeed high quality businesses in general) and this style of investing is prone to many of the behavioural biases that support excess returns from value investing in the first place.
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Are value strategies riskier than glamour strategies?

There are two schools of thought as to why value strategies have historically outperformed glamour or growth strategies. The first is value strategies are riskier than passive strategies. This is intuitively appealing when we consider the nature of value stocks. These companies are typically plagued with investor concerns, surrounded by popular pessimism and often have high levels of financial and operating leverage.

A brief look at the top 10 industrial stocks in the ASX ranked by free-cash-flow-yield highlights this point.

Different investors will perceive risk differently but for us the most crucial measure of risk is how particular portfolios perform in down markets. Figure 4 illustrates the can you pay uber with bitcoin of value strategies based on enterprise-free-cash-flow through a variety of market conditions. The point to note is that there is little difference in performance in up markets and down markets. If anything, the value portfolios perform better in more adverse market conditions.

Figures 3 and 4 highlight one of the challenges faced by many investors and their sponsors. The challenge is distinguishing between diversifiable risk (or company specific risk) and non-diversifiable risk (or systematic risk). By definition, best of value investing part 2, company specific risk can be diversified away whereas systemic risk cannot, best of value investing part 2. Myer &#; a department store &#; might appear to be a risky investment. However, investors should be only be concerned with how the stock performs within the context of a portfolio and how such a portfolio is likely to perform in a meaningfully down market.

Indeed, when we invest in businesses we place significant weight on understanding and quantifying downside valuation scenarios and their dependencies on uncontrollable external influences such as macroeconomic conditions. These are “systematic risks” that cannot be diversified away. This “margin-of-safety” concept is explicitly considered when we develop our “conviction scores” that combine with valuation to determine portfolio weights.

Concluding comments

The performance of value investing on the basis of free-cash-flow in an Australian context has been compelling and, in our view, represents a strong foundation for active stock selection. This key finding underpins Merlon’s investment philosophy which is built around the notion that companies undervalued on the basis of free-cash-flow and franking will outperform over time.

Any investment philosophy needs to be supported by an understanding of whya particular approach is likely to generate excess returns. In this paper we begin to explore this question. Consistent with our philosophy, we present findings that show a linkage between value investing on the basis of free-cash-flow and earnings quality. We then go on to dismiss the notion that value investing is “riskier” than passive alternatives.

In our third paper in this series to be released next quarter best of value investing part 2 will highlight a number of well documented behavioural biases that are empirically and anecdotally evident in the Australian market. We will also point to various elements of the Merlon investment process, structure and culture that are aimed at minimising our exposure to these biases.

Author: Hamish Carlisle, Analyst/Portfolio Manager

[1] See: “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?”, R Sloan &#; The Accounting Review

[2] See, for example: “Value-glamour and accruals mispricing: One anomaly or two?”, H Desai, S Rajgopal, M Venkatachalam &#; The Accounting Review,
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Value vs. Growth Investing: Which Should You Buy?

Value investing and growth investing are two different investing styles. Usually, value stocks present an opportunity to buy shares below their actual value, and growth stocks exhibit above-average revenue and earnings growth potential.

Wall Street likes to neatly categorize stocks as either growth stocks or value stocks. The truth is a bit more complicated since some stocks have elements of both value and growth. Nevertheless, there are important differences between growth and value stocks, and many investors prefer one style of investing over the other.

Image source: Getty Images.

Growth stocks

Growth companies prioritize going from small, up-and-coming businesses to leaders in their respective industries as quickly as possible. Early on, these types of companies tend to concentrate on building up their revenue, often at the cost of delaying profitability. After a period of time, growth companies start focusing more on maximizing profits.

As those key financial metrics grow, the perceived value of the company rises in the eyes of growth-minded investors. That can create a positive feedback loop. A rising stock price can boost a company's reputation, best of value investing part 2, helping it win even more business opportunities.

Growth stocks tend to have relatively high valuations as measured by price-to-earnings or price-to-book value ratios. However, they also see faster growth in revenue and income than their peers.

Value stocks

Value stocks are publicly traded companies trading for relatively cheap valuations relative to their earnings and long-term growth potential.

Value stocks don't have flashy growth characteristics. Companies considered value stocks tend to have steady, predictable business models that generate modest gains in revenue and earnings over time. Sometimes you can find value stocks with companies that are in decline. Still, their stock price is so low that it understates the value of their future profit potential.

Which is better: growth or value?

Both growth stocks and value stocks offer lucrative investing opportunities to their shareholders. The best investment style for you depends largely on your personal financial goals and your investing preferences.

Growth stocks are more likely to be appealing if the following apply to you:

• You're not interested in current income from your portfolio. Most growth companies avoid paying significant dividends to their shareholders. That's because they prefer to use all available cash by reinvesting it directly into their business to generate faster growth.
• You're comfortable with big stock price moves. The price of a growth stock tends to be extremely sensitive to changes in future prospects for a company's business, best of value investing part 2. When things go better than expected, best of value investing part 2, growth stocks can soar in price. When they disappoint, higher-priced growth stocks can fall back to Earth just as quickly.
• You're confident you can pick out winners in emerging industries. You'll often find growth stocks in fast-moving areas of the economy such as technology. It's common for many different growth companies to compete against each other. You'll need to pick as many of the eventual winners in an industry as you can, while avoiding losers.
• You have plenty of time before you'll need your money back. Growth stocks can take a long time to realize their full potential, and they often suffer setbacks along the way. It's critical that you have a long enough time horizon to give the company a chance to grow.

Value stocks may look more attractive if you seek out these characteristics:

• You want current income from your portfolio. Many value stocks pay out substantial amounts of cash as dividendsto their shareholders. Because such businesses lack significant growth opportunities, they have to make their stock attractive in other ways. Paying out attractive dividend yields is one way to get investors to look at a stock.
• You prefer more stable stock prices. Value stocks don't tend to see very large movements in either direction. As long as their business conditions remain within predictable ranges, stock price volatility is usually low.
• You're confident you can avoid value traps. In many cases, stocks that look cheap are value traps, or cheap for a good reason. It could be that a company has lost its competitive edge, or it can't keep up with the pace of innovation. You'll have to be able to look past attractive valuations to see when a company's future business prospects are poor.
• You want a more immediate payoff from your investment. Value stocks don't turn things around overnight. However, if a company is successful in getting its business moving in the right direction, its stock price can rise quickly, best of value investing part 2. The best value investors identify and buy shares of those stocks before other investors best of value investing part 2 on.

Finally, when it comes to overall long-term performance, there's no clear-cut winner between growth and value stocks. When economic conditions are good, growth stocks on average modestly outperform value stocks. During more difficult economic times, value stocks tend to hold up better. Therefore, best of value investing part 2, which group outperforms depends a lot on the specific time period you're considering.

Tracking growth and value indexes

These trends can be seen in growth and value indexes, which are benchmarks designed to track each group of stocks. The S&P Growth Index (NYSEMKT:SPYG) draws from the roughly stocks in the S&P It selects the stocks that have the best three-year growth in revenue and earnings per share with the strongest upward momentum in price. The S&P Value Index (NYSEMKT:SPYV) selects stocks best of value investing part 2 the best valuations based on several major stock valuation metrics.

There's no reason you can't own both growth stocks and value stocks. Each group has its own attractive qualities. Having diversified exposureto both in your portfolio can give you the best of both worlds.

It's also fine if you identify more with one investing style than the other. Once you settle on your goals for your investments, you'll have a better sense of whether best of value investing part 2 a growth investor, a value investor, or a bit of both.