Value, growth, and momentum are the 3 hats worn by an investor. All three of these are different stock-picking strategies that have stood the test of time. Each method has its advantages and disadvantages, and whether it's suitable for you depends entirely on your personality rather than your skills.
Yes, that's right! Your emotions, risk aversion, and fear determine which strategy you should select to maximize utility. Let us explore that by today, and at the end of the article, you will get the answer to your personality type.
Value Investing is probably the oldest technique in stock picking. The concept is simple: find stocks that are priced below their intrinsic value. For example, if the intrinsic value of a stock is 1200 and it's now trading for 1000, then it's a value stock.
To find the relative intrinsic value, there are many tools available. Price-to-Earnings (P/E), Price-to-Book Value (P/BV), Price-to-Cash Flow (P/CF), and Price-to-Sales (P/S) are a few of the relative valuation ratios available.
The important factor in all these is the “Price” of the stock, and since it's the numerator of the ratio, a fall in price, with fundamentals, book value, cash flow, or sales remaining unchanged, is what is required to drive up the “value” of the stock.
For an investor, finding a value-for-money stock is the easiest part. They just have to monitor the share price of a decent company. A decent company means one with steady/strong earnings, cash flow, and profitability. So, we need a good company's share price to fall and stay below its intrinsic value to become a good value investing pick.
One of the many reasons prices are staying low is poor demand for the stock with a supply overhang. Buying these kinds of companies is a good long-term bet, as their fundamentals are quite strong and the market will recognise them sooner or later. But the problem is that no one can say when prices will trade at a premium to their intrinsic value and create wealth for the investor.
If your nature is to buy things at a fair value, wait for clearance sales, and spend money frugally, then value investing makes perfect sense. As a shopper, you would never regret paying high prices, as you are well aware that you got it cheap. Value investing is always about buying good companies and not just buying something that's trading cheaply.
Growth Investing is another popular stock-picking strategy. The idea is to buy companies that consistently grow their sales, profits, market share, and cash flows. These are the companies that disrupt the market with their latest inventions, technological progress, or innovative strategies. An ordinary company could become a growth stock if it expands its business, customers, product range, or market share through mergers and acquisitions.
Finding a growing company is the most important part of the equation, but the problem could be its share price. Since everyone knows that a growing company attracts more investors, the overwhelming demand can drive up the share prices.
This means the relative valuation of growth companies would be on the higher side, i.e., a higher P/E, P/BV, P/S, etc. This also means the share prices of these companies are higher, and investors are ready to pay them because they anticipate higher future sales & earnings growth.
A high-growth company is rarely cheap; the idea is to always buy it at a reasonable price and exit at a much higher one. Investors focus on holding the stock as long as earnings are growing and exiting partially/fully if growth stagnates. This is because, once growth stops, demand for their shares will decline, leading to normalised share price premiums.
If you love buying the latest gadgets, upgrading your existing arsenal with the newest tools, and being an early adopter of new innovations, then growth buying is your cup of tea. These gadgets are always priced at a premium, and owning them becomes more about pride than purpose. Once the technology changes, you end up switching to the next gadget. Loyalty is hard in growth stocks.
Momentum Investing is about finding outperforming stocks and holding them until the trend reverses. When we say outperformance, it mostly refers to the share price. Over a period of consideration, say 6 months or 1 year, if a firm’s share price trend is increasing, it's a good candidate for momentum investing.
An investor could buy this stock in hopes of riding the momentum and exiting at a higher price. There are many reasons why a company's share price remains high. One of them could be due to a noticeable improvement in the company’s financials, fundamentals, and market share.
Momentum investing became a clear winner due to the popularity of passive index investing. In an index such as the Nifty50, if a stock has a 10 per cent weightage and its share price rises, it is bound to attract more capital due to passive investing. This new capital will further fuel demand for the price, thereby increasing its index weightage.
The problem with momentum investing is that a price decline could fuel a downward spiral. The index funds may have to sell the shares to accommodate the reduced weightage, further weakening the share prices. So, the momentum could impact both ways—upside as well as downside.
From a behavioural standpoint, momentum investing could be compared to brand loyalty based on popularity. For example, you might be a fan of brand ABC, but then the new talk of the town would be brand DEF. This is where you ditch brand ABC for brand DEF. After a few months, a new brand comes up, GHI; you would not hesitate to go after that. Basically, you are following the current market trend and adapting to it.
While the three styles of investing—Value, Growth, and Momentum—require a company to be fundamentally sound, it could happen even without that. This is when you get trapped.
If a company is trading significantly below its intrinsic value but has weak fundamentals, it is a value trap. If a company promises strong earnings growth but delivers poor results, it's a growth trap. If a company with high price momentum experiences a price decline, it's a momentum trap.
Value, Growth, and Momentum are excellent standalone methods to pick stocks, but hybrid or combo strategies are also available and are fast gaining traction; they are:
- Value with Growth—Finding stocks that are below their intrinsic price but experiencing significant growth in their fundamentals.
- Growth with Momentum—Finding stocks that are growing their fundamentals and also experiencing a steady increase in their share prices.
- Value with Momentum—Finding stocks that are having a steady rise in prices but are still below their intrinsic valuations.
Based on your personality, you could choose the investment method that best maximises your utility. When your character type and the chosen investment method match, you attain peak satisfaction.
The writer is a SEBI Registered Investment Adviser (INA000021757), SEBI Registered Research Analyst (INH000025045), and author of ‘How to join the top 1% options traders club’.
DISCLAIMER: Investments in the securities market are subject to market risks, including the potential loss of principal. Past performance does not guarantee future results. Information provided is for educational purposes only and should not be considered financial advice. Investors should read all related documents carefully and consult a certified advisor before investing. Registration granted by SEBI and Enlistment with RAASB/BSE and certification from NISM in no way guarantee the performance of the intermediary or provide any assurance of returns to investors. The investor is requested to take into consideration all the risk factors before actually trading in stocks or derivatives.
The opinions expressed in this article are those of the author and do not purport to reflect the opinions or views of THE WEEK.
