Growth and Value Stocks

How to shop for

growth and value stocks

hen thinking about how to buy stocks, it’s probably best to start with one of the most successful investors of all time: Warren Buffett, CEO of Berkshire Hathaway. Buffett favors understandable businesses with good balance sheets, high returns, reasonable valuations, and strong market positions. His approach has led him to earn market-beating returns over decades of investing.

Buffett is known is as the archetypal buyer of what are called value stocks (those with low price-to-earnings or price-to-book ratios). At Barron’s, we like those stocks too, but we also think it’s worth following growth stocks (those companies with rapid earnings and revenue growth).

Below are a few of the rules that we follow (and, yes, occasionally break) when sizing up a stock, whether it’s a growth stock or a value stock.

Sizing up growth stocks

LVMHF

VFC

When buying growth companies, look for dominant businesses and don’t overpay. Try not to pay more than 25 to 30 times forward earnings, a multiple that is expressed as the price-to-earnings ratio or P/E. While professional investors often derive their own earnings estimates, individuals can base this stat on consensus numbers, which are the combined estimates of analysts covering the stock.

If you pay more than 25 or 30 times forward earnings even for an excellent company you are vulnerable to the slightest earnings or revenue disappointment. And even if growth pans out, the stock may not appreciate as investors worry about sustainability and the P/E multiple contracts.

It’s also important to be careful about fads. Shortly after its 2015 initial public offering (IPO), Fitbit (FIT) stock traded for nearly $48 a share, but as consumer enthusiasm waned for activity trackers so too did enthusiasm for the stock, which ended 2018 at less than $5 a share. Similarly, be wary of fashion-oriented companies whose stock prices can fluctuate sharply as individual brands fall in and out of favor.

Better to stick with diversified apparel and accessories makers, such as VF Corp. (VFC) and LVMH (LVMHF), parent of luxury goods maker Louis Vuitton. Instead of betting that one designer will continue to excite consumers, you’ll be aligning yourself with successful operating companies that have succeeded even as tastes changed.

Spotting a good value stock

When selecting value-oriented stocks, try to find those with some earnings growth or alternatively, select ones that are valued so cheaply relative to book value (assets minus liabilities) or earnings that they don’t need much growth to be good investments. A rock-bottom valuation would be less than 75% of book value or eight times earnings. Financial companies make up the largest component of the value-stock universe. When investing in big banks and insurers, try not to pay a big premium relative to tangible book value — a conservative measure of shareholder equity that excludes goodwill and other intangible assets from acquisitions. In theory, book value should approximate liquidation value, offering a floor under the stock price. If you can buy a solid financial company at tangible book value, it has a good chance of working. Try not to pay much more than 1.5 times tangible book or 15 times current-year earnings. This strategy can pay off in a big way as these stocks tend to be highly cyclical. As the economy ebbs and flows, investors get an opportunity to buy financials cheaply. Barron’s wrote favorably on Goldman Sachs (GS) in mid-2016 after it was battered on Britain’s vote to leave the European Union and traded around $142, a discount to tangible book value. With financials back in vogue after Donald Trump’s election win, Goldman shares soared to $275 a share in early 2018, though market volatility later in the year knocked them down to $176 a year later. The price-to-book guidelines for financials using book value don’t apply to asset-light financial companies like Visa (V) and Mastercard (MA), which benefit from the steady growth of debit- and credit-card transactions at the expense of cash. They trade at much higher price-to-book multiples.

FIT

Don’t be put off by a high absolute stock price, which in and of itself has nothing to do with valuation. A triple-digit share price simply reflects an unwillingness of management to split shares. Focus on the stock price relative to earnings — and book value when relevant. In fact, stocks with high absolute prices sometimes are inexpensive relative to cheaper brethren in the same industry because many investors recoil at a high stock price. Berkshire is the best example. Buffett has refused to split the A shares (BRK.A) — although the company created lower-priced class B shares (BRK.B) about 20 years ago. Not buying the A shares in the 1970s and 1980s when they traded in the hundreds or even thousands of dollars was a huge mistake, with Berkshire’s shares recently trading around $300,000.

A final rule for picking stocks? Patience. It can take time for the market to come around to your thesis. Trading in and out of shares is rarely a formula for success.

Glossary terms

Stock prices are all relative

Price-to-book ratio: The ratio of a company’s stock price to its book value, i.e. the net value of assets on its balance sheet. Price-to-earnings ratio: The ratio of a company’s stock price to its earnings per share over four quarters, past or projected. Consensus estimate: The average of analyst predictions for a company metric, like earnings per share, for a future period, such as the next quarter or the current fiscal year. Growth investing: An investing methodology that looks for companies whose sales and earnings are expected to increase at a faster rate than that of the market average or the average of their peers. Value investing: An investing approach that tries to identify stocks that are temporarily underpriced by the market. The idea is that current perceptions about the stock do not reflect its potential and that eventually the market will recognize the company’s true value.

Source: Barron's | This infographic was created by Avalaunch Media

Download PDF version of eBook

Watch Video

Earnings and market valuation

Introduction

By Barron’s – 03/27/2019

Published by Fidelity Interactive Content Services

Earnings and market valuation

Based on what he’s seen so far this earnings season, Art Hogan of National Holdings Corp. believes stocks are fairly valued with some notable exceptions.

[Click on the terms below to open a related article for more details]