Value Investing: Common Alternatives to Value Investing
There are dramatic differences in the ways different types of investors make their investment decisions. In this section, we'll look at some of the most common investment philosophies and see how each one compares to value investing.
Unlike value investors, growth investors are not concerned with a stock's current price nor with how that price relates to the stock's intrinsic value. It doesn't matter as much to them if a stock is a bit overvalued, as long as its price is rising and is expected to keep going up. While growth investors and value investors both expect to profit from appreciation in stock price, growth investors want to see a 5-year projected growth rate of 10% to 15% per year and want an investment which has the potential to double in about 5 years, which is fairly quickly. Value investors have a longer time horizon – they may hold stocks for decades – and they are not worried if the stock's price drops in the short run or about the speed or percentage rate at which the company is growing.
Like value investors, growth investors care about the underlying company's profit margins. If the company is experiencing earnings growth but expenses are also growing, then profits are not growing and the company may not meet growth investors' goals. Both value and growth investors also compare a stock's data to industry averages to get a sense of how the stock is performing comparatively and where the stock's price might be headed. Finally, growth investors and value investors both strive to achieve returns that exceed industry and market averages, and a growth stock can actually be a value stock if it is priced appropriately and has sound fundamentals. (Learn about other styles of investing in Build A Model Portfolio With Style Investing.
Like value investors, income investors are concerned with safety and principal preservation. However, income investors may look beyond stocks when seeking income-producing investments. Income investors may also consider investment-grade bonds, annuities and perhaps rental properties or real estate investment trusts (REITs). Some value investors also see real estate as a value investment, but in general, value investing is focused on stocks.
Income investors and value investors both want to own the stocks of established, profitable companies; however, income investors make sure to acquire stocks that have a history of sharing their earnings with investors in the form of dividends. Value investors are not concerned with the cash flow an investment generates; they seek to make their money from stock price appreciation. Income investors can make money just by holding stocks – they don't have to sell to make a profit.
Income and value investors are both concerned with a stock's fundamentals. Income investors must be careful to choose stocks with strong fundamentals because if the company starts losing money or goes out of business, not only will there no money to pay dividends, but investors will also lose their principal.
If their holdings are not in a tax-advantaged account, income investors can experience greater losses from taxes than value investors do because income is taxed at a higher rate than long-term capital gains. That being said, value investors often own income-generating stocks: Just look at the holdings of Berkshire Hathaway. (Don't get forced into action. Learn how to plan properly to avoid making rash decisions, check out Reinvesting Capital Gains In Leveraged Portfolios.)
Of the four types of investing profiled in this section, technical analysis is perhaps the most different from value investing. Technical analysts completely ignore the value of the companies whose stocks they purchase and only look at the movement of stock prices. Technical analysts are not interested in a company's financial statements and don't perform any fundamental analysis when making investment decisions. Instead, they base their trading decisions on patterns in stock price and trading volume based on historical data. Technical analysts assume that there are trends in the way stock prices behave, and that they can spot those trends and profit from them by timing their trades correctly. Technical analysis is a short-term, active trading strategy, not a long-term, buy-and-hold strategy like value investing.
TUTORIAL: Technical Analysis
The only thing that technical analysts and value investors have in common is that they both believe it is possible to achieve returns that beat market and industry averages. However, some traders who are neither pure value investors nor pure technical analysts believe that the two methods can be used together to determine the most profitable times to enter and exit trades.
An index fund is a type of mutual fund whose investment strategy is to mimic the performance of a particular index, such as the S&P 500 or the Russell 2000. Index fund investors believe in the efficient market hypothesis, which says that stocks are always correctly priced and it is not possible to beat the market, while value investors believe that stocks can be over- or under-priced and that it is possible to beat the market.
Value investing is a somewhat active strategy because it involves researching and selecting individual stocks and monitoring their performance, but it is also a somewhat passive strategy because it has a long investment horizon and infrequent trading activity. Index fund investing is considered a passive strategy because index funds are created by purchasing all the stocks in a particular index rather than by having a mutual fund manager choose specific stocks to invest in. However, a smart index fund investor will still be active in choosing which index funds to invest in. Different indexes have different risk and return profiles, and it is important to track down funds with low expense ratios that won't drag down returns. (Read more in our Index Investing Tutorial.)
Index fund investors do not choose the companies they own and may not even know which companies they are invested in (who can name all the companies in the S&P 500, let alone a larger index like the Russell 2000?). They certainly aren't concerned with the fundamentals of individual companies – they couldn't be even if they wanted to, because there are more individual companies in an index than anyone could reasonably keep track of. Index fund investors are very broadly diversified and generally own stocks of hundreds of companies. Value investors are likely to own the stocks of perhaps 10 to 50 companies – a number that they can reasonably keep tabs on, since they consider themselves investors in the actual companies represented by the stocks, not just speculators in the stock market. Also, since index fund investors aren't choosing specific stocks, they don't need to know anything about corporate finance.
Perhaps the only thing that index fund investing and value investing have in common is that both are considered by their proponents to be long-term, conservative strategies. However, a value investor might tell you that investing in index funds is a risky strategy because it won't generate high enough returns, while an index fund investor might tell you that value investing is a risky strategy because it requires investors to correctly pick just a few winning stocks. That being said, Buffett advocates that the average person invest in index funds. (Read about the Greatest Investors of our time.)Value Investing: Conclusion
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