There are two types of investors in the stock market: growth investors and value investors.
Growth investors look to buy emerging companies with great growth rates. Value investors look for distressed companies that are trading at below average prices. Both types of investors can reap positive returns in the stock market. But what type of strategy is best for an investor in their 20’s? Let’s take a look:
Google, Amazon, and Research In Motion have all been great growth stories over the past few years. These companies didn’t fly below the radar or trade at single digit P/E ratios but that didn’t stop them from being great investments.
Growth investors are willing to pay a premium for companies with growth rates that are above the industry average. The best example of a growth investor today is Jim Cramer. He loves stocks with above average growth rates that are blowing out analyst expectations. It is rare that you will find a great growth company selling at a discount. They are far more likely to be trading near their 52 week highs.
General Electric, Cheesecake Factory, and Bank of America were all risky investments over the past few years. These stocks were all trading for $5 or less just two years ago because of fears of an economic collapse.
Value investors love exactly this kind of opportunity.
Market downturns are seen as opportunities to buy a great company on sale. Warren Buffett is probably the greatest value investor that ever lived. He has historically used market dips to buy shares of great businesses selling cheaply. Value investors are far more likely to buy a stock trading near its 52 week low than its high.
So, which strategy is best for young investors? The answer may surprise you.
It would appear that a growth investing is the best strategy for young investors since you want maximum capital appreciation but in my opinion the best philosophy is to a hybrid approach. A hybrid approach involves taking the best aspects of growth and value investing. Look for companies with above average growth rates that the market has mispriced for some reason. It could be due to a short term problem such as an earnings miss or fear of a new competitor. Whatever the reason, you should look to pounce when the market puts a great growth story on sale.
Famed Fidelity Magellan fund manager Peter Lynch followed this approach. He sought to buy companies with high growth rates that were selling cheaply based on their potential.
Lynch’s favorite metric for finding a cheap growth stock was to look at price to earnings growth. Price to earnings growth (PEG) is a comparison of the P/E ratio to the growth rate. It helps investors determine just how much to pay for a stock. Lynch believed that a fairly valued company has a PEG ratio of one. This way the P/E ratio was equal to the growth rate. An overvalued company has a ratio greater than one and an undervalued company has a PEG less than one. You want to invest in companies whose PEG is less than one.
What type of investor do you consider yourself? Which approach do you think is the best?