Once you decide to start investing in the stock market, the obvious question is---which stocks should you buy?
Very often, their predictions turn out to be completely off the mark.
What a serious investor needs is a philosophy of investing, a style that enables you to pick stocks.
There are, of course, plenty of styles------traders, for instance, swear by technical analysis, while the more long-term investors are more inclined towards fundamental analysis.
But even within the "fundamentalist" camp, there are competing styles.
And the styles with the largest followers are "value investing" and "growth investing."
Growth
Growth investors look for companies with rapidly growing earnings.
They are willing to pay a fairly high price for a stock whose earnings they expect to rise sharply.
They aren't particularly bothered whether a stock is cheap or expensive. Stocks are cheap when their Price-Earning ratios or Price-Book ratios are low, and expensive when their PE and PB ratios are high.
P/B ratio
Book Value is what would be left over for shareholders if the company were sold and all its loans were paid off.
In technical terms, BV is the accounting value of a firm.
P/B is calculated by subtracting total liabilities (money owed) from total assets (all that it owns) and dividing the result by the total number of shares.
So a BV of Rs 39 would indicate what each share owner would get at this point if the company liquidated.
P/E ratio
The Earnings Per Share is arrived at by taking the company's net profit and dividing it by the total number of shares.
The PE ratio is the market price of the share divided by the EPS.
Investors expect that high earnings growth will more than make up for the high PE.
If they believe it will deliver high earnings growth, they'll go for the stock.
A growth investor therefore bets on continuously rising earnings. Such stocks usually have high valuations. Meaning, they have a high PE or a high PBV ratio.
Some such stocks are Pantaloon (aggressive growth targets given by company, currently opening new malls at a fast pace), Bharti Telecom (growth has been higher than that of IT companies for quite a few years in the past and is expected to continue the same way, subscriber growth projections are high), Suzlon Energy (bright prospects for alternate energy sources and the company already has a large market share).
Value
Value investors, on the other hand, are those on the lookout for a stock that is being quoted below what the investor believes is its "fair value" or "intrinsic worth".
He believes that these are stocks that the market has not yet discovered and hence they quote below their true worth.
Normally, such stocks exhibit low PE multiples and are also less volatile than growth stocks.
These stocks are usually found in mature industries like steel, commodities, fast-moving consumer goods and so on. Examples include Tisco---an established business, steady growth; Nestle---an established business, diversified portfolio of products, brand equity; ONGC---largest oil explorer, vast reserves, major beneficiary of oil price increase.
At times, such stocks also show high dividend yields.
Dividend yield
The dividend yield of a company is the dividend per share divided by the price per share. It's often expressed as a percentage.
Let's say the share price = Rs 36
Annual dividend: Rs 0.88
Dividend yield: 2.44% (0.88/36.00)
Historically, a higher dividend yield has been considered to be desirable among investors. A high dividend yield is considered to be evidence that a stock is underpriced, whereas a low dividend yield is considered evidence that the stock is overpriced.
Which style is better?
Value investors often say that they have a greater "margin of safety". That's because the beaten down stocks that they pick are out of favour with the market, and nobody has any great expectations about them.
Often they are stocks that the mass of investors haven't discovered yet, hence they are not closely followed.
If these companies have an earnings disappointment or two, the price of the shares don't fall by much. But they respond very positively to good earnings.
Growth stocks, on the other hand, have great expectations built into them and are closely followed, which means that earnings disappointments hit them really hard.
Growth investors point out that, in their quest for undervalued stocks, value investors are often drawn towards small cap and mid cap stocks, which may not have much liquidity, carry a higher risk and which may be volatile.
It's also true that different styles perform better at different times.
For example, when the economy is in a recession and corporate earnings are down in the dumps, attention shifts to safety rather than to growth. That's when value investing usually comes into play.
In contrast, during boom times, when the economy is powering ahead on all cylinders and optimism is all around, people tend to believe that growth will last for ever. That's when growth stocks come into favour.
To take an extreme example, during the tech boom in the late nineties, nobody bothered about finding value in beaten down old economy stocks----the rage at the time was tech stocks which were supposed to deliver superior earnings growth. The fact that these stocks had PE ratios of a 100 or so, while some of them didn't even make profits didn't deter the die-hard growth investor. We all know, of course, what happened to those stocks later on.
A merger of both?
There are also hybrid approaches. For instance, some investors have a "relative value" approach to identifying value stocks.
This approach is therefore a combination of growth and value investing styles. The point is to pick, not intrinsic value or growth, but growth or value compared to the company's peers.
This means that they compare a stock's P/E ratio to those of other companies in the same industry, or they estimate future earnings estimates or cash flows and compare that with other companies in the same industry.
In other words, these investors are those that believe in investing in stocks which they feel are undervalued compared to their peers in an industry, or which they believe will grow faster than other companies in the industry.
A marriage of both the styles may be a better idea than sticking to one method. Such an approach will enable the investor to select a portfolio that could benefit through changing market and economic cycles and lessen the effects of market volatility.
Growth and value stocks historically have tended to follow a cycle of one style outperforming the other for a period of several years.
Over the long term, therefore, investors can potentially enhance returns and reduce risk by including both growth and value investments in their portfolios.
Illustration: Uttam Ghosh