In recent times the talk of growth stocks has almost taken over the whole idea of value. What differentiates them from value stocks? Very briefly — as the name suggests, growth stocks are shares of companies whose earnings are expected to grow at a rate higher than the market rate. Value stocks on the other hand are the ones which are available below their intrinsic value of true worth.
In the first case the investor is betting on a high future progress which he hopes will translate into an inflated share price while in the second case, the intention is to buy the share as it has temporarily fallen below its true worth and with time it will start trading higher again. The reason for such temporary fall in price could be any — setback in business plans, general slowdown in economy, increasing competition etc. An investor must be careful to ensure that the fall in price, offers true value (i.e. that it is not a ‘value trap’). In other words, the fall is due to a curable problem and once cured, the share will trade higher. For example — in case of increased competition, if the company is likely to withstand the competition and emerge as a leader, then the fall in price may sure offer value, if not, there is a genuine case of loss of market position and diminished value.
Blue Chip Vs Growth Stocks
The term ‘blue-chip’ is used for stocks of well established companies with a strong financial position which have consistently improved their earnings and have withstood many economic downturns. Value investors in particularly look to buy blue-chips when there price falls below their intrinsic value — the concept of value investing.
What differentiates growth stocks is the very rule of investing which puts emphasis on future earnings rather than current price which is why they often command high price earnings multiple (PE). In other words, growth investors buy in anticipation of future progress, even though such progress may be unprecedented in the previous track record of that particular company.
Benjamin Graham, in his book Security Analysis spoke of individual growth as basis of selection. Stressing on the element of selectivity he stressed that certain favored companies grow steadily and could hence be brought as long-term investments. The earnings of such companies move forward from (economic) cycle to cycle and are only interrupted by periodic business depressions. The book delves further into an investigation of what constitutes a growth company and – (i) how investors can identify them; as also (ii) how to assess the right price to pay for them.
One distinction which the book did not make was of – blue chip vs. growth stock beyond stating that:
“Choosing newer companies with short record of expansion, an investor runs the risk of being deceived by temporary prosperity; and if he chooses enterprises that have advanced through several business cycles, he may find this apparent strength to be the harbinger of coming weakness”.
Much as I find, Security Analysis one of my all time favorite books on finance, I must admit that the world has changed dramatically since the time the first edition of this book was written. These days it is increasingly becoming hard to spot the companies which will keep getting better from cycle to cycle. Technology has the ability to kill a 100 year old company in literally a few months time. The perfect case in point is Mahanagar Telephone Nigam (MTNL) — considered as one of the best stocks for long term bets of the bluest eyed boys in the asset management world. Along came Airtels, reliances, Vodafones etc., and MTNL is not so favorite anymore. And I thought at one time it was a “buy and forget” kind of share? Further, economic cycles have become short (In the last 12 years, India has seen 3 purported recessions and 2 equity market booms), so the whole notion of cycle to cycle, begs the question ever more – how many cycles? ITC (the cigarette company), Colgate (the toothpaste maker) and Maruti (the car maker) are likely to lose market share more quickly today than it was even imaginable until a few decades ago.
Final Word–Pay more attention to future than the past record
Coming back to the blue chip vs. growth stock debate – While I believe that latter are likely to grow more aggressively (given that they have not grown as big as a blue-chip company and hence have a lot more room for expansion), there is no reason why they should be considered any riskier than a blue chip. If you have faith in your stock selection criteria and your expectations of future; and if in your opinion the current price is justified – go ahead and buy into that growth.
Nicely explained. You should give some examples too.