Recently, I’ve been writing a lot about specific investment strategies that target three of the four main forays into the market: growth, value and yield. The fourth category is low risk, which we’ve talked about often here at the Women’s Financial Alliance.
But here’s the thing… These terms get thrown around so much that they lose their meaning.
When we say “value,” many investors think “cheap,” or at least cheap relative to the rest of the market. But what exactly does value mean, and how can we use it to pinpoint investment opportunities?
Let’s take a clear look at each of these three strategies to see if we can make sense of what they mean in the real investment world.
Growth
When we talk about growth, one of the most important bits of data to consider is revenue. This is obvious, of course. Increasing revenue literally means a company is growing. But your analysis shouldn’t stop there, because it’s just as important to know where that revenue came from.
I don’t mean geographically… I mean, did it come from sales or cost cutting? How much did the company spend to make that revenue? These kinds of questions point to the true growth potential a company has.
That means investors should also consider if a company has high and/or increasing profit margins and if the company’s expenditures are translating into revenue.
Consider this: When oil prices were trading near $100 per barrel, a company that spent $40 per barrel to find and produce that oil could be considered a growth company because its profit margins would be substantial. But as oil prices fell, those profit margins are wiped out. And what if oil prices had remained high but the costs to extract oil dramatically increased? Sales may jump as the company pumps more oil, but again, profit margins fall as costs climb.
So a comprehensive growth strategy should include increasing revenues, high or increasing profit margins and a decent return on capital invested. Using these criteria will give you a far deeper understanding of a company’s revenue and earnings potential than any single sales figure.
Value
The first name that comes to mind when investors think about value is Warren Buffett. No surprise there. He’s the king of buying strong companies at a great value. But this wasn’t always the case. In the beginning, Buffett bought basement-bargain stocks and waited for a bump in share prices to take a profit. An investor following this advice to a “T” would seek out the lowest price-to-earnings ratio (P/E ratio) regardless of other fundamental figures.
Buffett called this “cigar-butt investing.” A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit, he said. “Unless you are a liquidator, that kind of approach to buying businesses is foolish.”
Instead, as he learned from his partner Charlie Munger, he says “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
And that’s because real value offers stronger – and more stable – returns than plain old cheap stocks.
That means you should be looking beyond a company’s P/E ratio for value. Real value investors should also be looking at debt-to-equity ratios (D/E ratios), the value of the enterprise relative to sales and profitability, to name a few. In other words, you want good, solid financial performance in addition to a low P/E multiple.
Yield
A yield strategy is deceptively difficult to pin down. Many investors (and analysts, for that matter) consider only dividend yield when using this strategy.
In my opinion, as you can probably guess from our conversation thus far, it’s not enough to look at just a company’s dividend yield. Share prices can really swing dividend yields in a very short period of time. The metric is taken from the dividend amount divided by the share price. If a company’s share price drops significantly but its dividend payout stays the same, the dividend yield percentage increases.
While higher yields can be a boon to your portfolio, if you’re buying and holding a company for an extended period of time, as most yield investors do, doesn’t it make sense that your yield strategy should take more fundamental financial information into account?
One of the key things a yield investor wants – beyond a high yield percentage – is business stability. She wants to know how stable earnings and revenues are. Dividend payouts rely on profitability, so the more consistently profitable a company is, the more reliable dividends become… and the greater the potential for actual dividend increases.
Like a good growth strategy, yield investors should look for high and steady profit margins and stable revenue growth. This will help ensure sustained dividend yields over the long term.
A Good Portfolio
A well thought-out portfolio will have a good grasp of each of these three strategies, and investors will be able to look at companies with a clear understanding of each category. It’s kind of like juggling. There are several moving parts, and when each metric is carefully considered, you have a balanced, graceful strategy.
And when you overlay your own personal risk profile, you’ve got a custom investment philosophy for confidently navigating the markets.
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