Success on the stock market can be achieved in various ways. Depending on the character of the shares in which one wants to invest, the investment strategies one can resort to can be divided into substance or value shares as well as growth shares. And then there is the long-term alternative of quality stocks, also called compounders. Which is the best strategy? There is no clear answer, that would be too easy. Some go for value, others for growth and still others for quality. The success of the different investment styles depends not least on the market environment. Quality stocks remain a good investment for decades. However, they are rare and do not come cheap because of their long track record.

 

Growth stocks – expensive and little dividend

Growth stocks are dividend-paying stocks with a high price-to-earnings ratio or a high price-to-book ratio. The stocks are therefore expensive and often have comparatively low current earnings (a low return on equity) and a low dividend yield. What makes these stocks attractive is that investors expect corporate profits to rise at an above-average rate in the future. Contrary to a common thesis, growth stocks are statistically less risky than their opposite, the substance or value stocks. In a long-term historical comparison, the overall score is a tie between growth and value stocks.

Growth investment strategies try to identify future growth markets at an early stage and to pick out the companies that will benefit most from them due to their competitive position and market power. However, promising young companies in promising industries are also considered. In doing so, share price gains can often be achieved even if the company in question is still making losses in the initial phase.

Facebook can be used as a prime example of a successful growth investment. After an initially disappointing start on the stock market in May 2012, the share price of USD 38 per share rose only slowly until mid-2013, then climbed steadily, corrected in part significantly between July 2018 and March 2020, and then rose more steeply and steadily (to currently around USD 357 on 31 July 2021). And all this without ever having paid out a single cent in dividends. eBay and Amazon are also typical growth candidates, as are companies whose sales and profits have been rising for a long time because they operate in growth markets and are able to expand continuously.

 

Find growth stocks

An important indicator for finding a growth stock among the many possible stocks (stock picking) is the priceearningstogrowthratio (PEG). There are also more complex selection criteria, e.g., the Discounted Cash Flow (DCF) method. Here the company value is calculated based on the expected future free cash flow (what is available in liquid funds after deduction of costs). It shows what cash inflows can be expected in the future. Useful information on companies that are not yet profitable but whose sales are expanding strongly is also provided by the price-to-sales ratio (P/S ratio), which puts the price per share in relation to the sales per share. A KUV of 1 indicates a fair market valuation, while a KUV smaller (greater) than 1 suggests an undervaluation (overvaluation). The prerequisite, however, is that reliable figures are available. If there are extraordinary turnover movements or manipulations, the KUV loses its significance.

Earnings per share (EPS) is important for companies that make profits. This key figure can be found in every annual financial statement of a listed company. EPS is particularly informative in comparison with industry peers but should also be compared with the P/E ratio, as margins can vary from industry to industry.

 

Value shares – undervalued substance

Value stocks are typically shares in companies whose business model is considered sustainable, but which are currently considered undervalued. Often, they are market leaders. The temporary undervaluation can be explained by the inefficiency of the markets: It takes time for the market to recognise the undervaluation as such and correct it.

Value investors (their most prominent and successful representative is Warren Buffett) look for companies of substance that are traded on the stock market at a temporarily significant discount to their intrinsic value. The value approach was developed by the US economist and fund manager Benjamin Graham and described in his book “The Intelligent Investor” published in 1949. Graham’s disciple Warren Buffett has sworn by the value strategy for decades, which made him one of the richest men in the world: “It doesn’t matter whether it’s socks or shares: I buy branded goods – but only at a reduced price,” is Buffett’s credo.

Value investors are long-term oriented. They find suitable companies long before the market discovers them. Those who want to invest in value stocks need patience.
The investment horizon should be aimed at three, better even five years.

 

How does value investing work?

So, value investors do it the other way round like the broad masses and buy when others sell in panic. Because although the prices of shares can often fluctuate strongly, their intrinsic value usually remains relatively stable. This is the basic value idea: buy high quality at low prices.

This presupposes that the stock market prices of corresponding companies are temporarily below the actual book value. However, this undervaluation must be “unfounded”, i.e., only due to the general mood on the market. Then and only then should value investors strike. If the share price of a company falls due to justified factors, for example because sales are falling or profits are slumping, value investors should refrain from buying. It is not primarily the share price that is decisive for the purchase decision, but the intrinsic value of the company or the underlying share.

 

The intrinsic value

The intrinsic value facilitates the assessment of whether a share is fairly valued or overvalued or undervalued. The formula for determining the intrinsic value (share value) also comes from Benjamin Graham and reads:

Share value = earnings per share × (8.5 + 2 × the annual earnings growth in %).

To calculate the intrinsic value, one only needs the two variables earnings per share and annual profit growth in percent. For example, with earnings per share of CHF 1.50 and annual earnings growth of 3%, the intrinsic value is 1.5 x (8.5 + 6) = CHF 21.75. The same result is obtained by multiplying the earnings per share by the P/E ratio.

For an approximate calculation of the share value, the balance sheets of the company in question (five years in a row should be enough) must be used to be able to determine a meaningful average value. So much for the theory. In practice, the problem arises that one must either consult the annual reports of the past years or fall back on estimates by analysts. Unfortunately, there are often serious differences between the data sources.

In summary, Graham’s formula allows at best a rough assessment. For a meaningful basis for decision-making, further aspects are necessary, for example the question of who the most important competitors are and what development potential the industry of the company under consideration offers. Company and industry reporting should also be kept in mind. Once an investor has determined the valuation level, he should add a safety margin to the intrinsic value thus found to cushion price slumps due to negative events.

 

How do you recognise value stocks?

In the case of value stocks, the companies behind them are generally characterised by an easily understandable and proven business model. Value companies also have:

  • competent management,
  • a strong competitive position,
  • solid financing and
  • above-average earning power

The search or better the finding (stock picking) is the most difficult part of the value strategy. A high level of financial understanding and detailed company analysis are prerequisites for success. In addition, investors should limit their search to companies whose business they understand. Clues for undervalued shares are:

  • Quarterly results worse than expected;
  • falling markets and price corrections,
  • bad news that exerts pressure on the share price or
  • cyclical influences that adversely affect industries

Companies that offer a market-driven proposition (at favorable prices) in times of crisis can also be considered as value stocks.

 

Draw

Overall, the long-term track record of growth and value stocks is roughly a tie. Value stocks have performed marginally better over the past decades. However, the boundaries are blurring. Growth companies can move into the value category and, conversely, value companies can grow more strongly by opening new promising business areas for themselves.

In the peak phase of the “New Economy”, the growth strategy was the more successful form of investment – until the bubble burst. Those who had invested in the “right” companies at the time, such as Apple or Google, achieved considerable price gains.

The growth segment primarily includes high-tech companies, but also biotechnology, medical technology, and pharmaceutical companies. In the case of smaller companies and companies that have recently entered the market, however, there is a risk that the growth expectations, which usually depend on the success of a single product, will not be fulfilled. Ongoing and intensive monitoring of these companies is essential. Ultimately, each investor must decide which strategy he prefers based on his investment horizon and risk tolerance.

 

Quality shares are no longer cheap

Quality shares can be regarded as a third variant, but nevertheless a sub-type of substance shares. They are similar in their characteristics to value shares, but unlike them they are no longer undervalued.

Quality shares are shares in fundamentally strong companies that are suitable for long-term investment (ten years and longer): Sustainable growth, low risk, high return on capital and favorable valuation (but no longer undervaluation) are important quality characteristics. You take these stocks into your portfolio and can then “forget” about them. You profit from the increase in value that the quality company generates, almost automatically.

 

Proven, robust, solid

The Cologne-based asset manager Flossbach von Storch lists the conditions that quality shares or the companies in question should fulfil:

The business model. It should be proven and robust. There should be a future demand for the company’s products and services. The offer should have been constantly improved and further developed. This raises the question of market position. Can the business model stand up to the competition? Is there a “protective wall”, consisting for example of patents, licences, a strong brand, cost advantages, technology leadership, close customer ties?

The balance sheet. According to Flossbach von Storch, a quality company should have proven over a long period of time that it can reliably generate and increase profits. Debt should be comparatively low so as not to limit the scope for investment in the long term.

The quality of management. It determines the value of the company in the long term. Professional competence and experience of the management are necessary prerequisites, but they are not sufficient. The top management, the chairman of the board, is responsible for the corporate culture and its long-term strategy. Especially in times of extremely low interest rates and comparatively low growth rates, it is crucial for the company’s success to use the available capital in the best possible way, writes Flossbach von Storch.

The dividend. A company should have proven that it reliably pays dividends and regularly increases its payouts. But: it must also be able to afford the distributions. If, for example, a large part of the profits (or even the reserves) is used for dividend payments, this can have consequences for the company’s investments in research and development.

As with quality products, quality stocks are often more expensive than other stocks. Low interest rates have contributed to the fact that the stock markets have risen significantly in recent years. This had an impact on the price of quality shares: They are no longer bargains.

A popular ratio to express the valuation of a company is, as already mentioned, the price-earnings ratio (P/E ratio). The benchmark for a reasonable P/E ratio for quality shares is 20. This means that investors must spend 20 francs in market value for one franc in profit. The higher (lower) the P/E ratio, the more expensive (cheaper) the share appears. At least at first glance. In a historical comparison, the P/E ratio of quality shares – depending on the index – is slightly above the market average.

 

Not very suitable for evaluation

The problem with the P/E ratio is that a company’s profit is relatively easy to manipulate or calculate. Therefore, the P/E ratio should not be regarded as the sole beatific valuation criterion.

Asset managers therefore also consider the Free Cash Flow (FCF) in the valuation. The FCF is what a company has available in free funds after deducting all costs. The higher the FCF, the stronger the company’s financial strength. Because with this freely available liquidity it can invest, pay off debts, buy back shares or pay dividends. Another advantage of FCF is that it is much more difficult to calculate than profit and P/E ratio. But FCF is not the ultima ratio either, not least because it has to be calculated quite elaborately depending on the industry.

The question of whether to invest in growth stocks or value stocks may be misguided. “Investing in quality instead can alleviate headaches,” argues Louis Florentin Lee, Managing Director and Portfolio Manager and Equity Analyst at Lazard Asset Management. Outside the US, quality stocks have outperformed growth and value stocks over the past twenty years. In the US, Lee adds, investors with a ten-year investment horizon have outperformed the broader market with quality stocks since 1976, almost 50 years ago.

Stocks that deserve to be called quality stocks are also called compounders. They should have three characteristics: Maximum financial productivity, reinvestment of profit at similar rates of return to generate future growth and thereby value, and competitive advantages that should last longer than the market expects. In theory, competitive advantages dissipate over time and excess profitability falls close to the cost of capital. Investors who follow this line of reasoning are therefore surprised when a compounding company can maintain its financial productivity. According to Lazard Asset Management, this alpha potential is “empirically validated and time tested”.

 

Competitive advantages maintain profitability

Competitive advantages help companies to maintain their profitability. These can be factors such as proprietary technologies, an efficient network, licences, patents, and strong brands. Economies of scale, buyer power, large production facilities, regulatory barriers, cost advantages, technological leadership in the production of important components, etc. also contribute to transferring a company’s profitability into the future.

As the period of competitive advantage lengthens and companies earn more over time, compounding means that the valuation of companies with high financial productivity does not increase linearly (but more). All this contributes to the fact that such stocks blessed with quality growth are less volatile than the overall market.

 

Conclusion

Whether substance, growth, or quality – the choice is not easy. Those who want to save themselves the trouble and effort of analysis, evaluation and selection can resort to exchange-traded funds (ETFs). The fund management takes over the work and puts together a portfolio of the stocks in question. The offer is diverse and transparent. The essential information on the funds, such as performance and fees, can be accessed at any time. Competition among fund providers is quite intense, which benefits the quality of management. The investor benefits from this.


Manred Kröller
Financial journalist

 

 

This post has been translated automatically

 

 

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