There are two types of stocks that you will want to fill your portfolio with. These are growth stocks and value stocks. Growth stocks are those with statistically high levels of return and value stocks are those that tend to be undervalued. As a stock investor, there are several valuation tools that assist you in selecting the right stocks for inclusion in your portfolio. Balancing your portfolio by including a mixture of growth and value stocks allows you to minimize risk while still maximizing your potential gain. True diversification of your investment portfolio results from the strategic inclusion of both growth and value stocks in the proper amounts. If you want to effectively manage your portfolio you need to learn to classify stocks into their proper categories so that you can make effective purchases.
No matter what your specific investment goals, choosing the right stocks for your portfolio is possible through the use of proper valuation methods. In order to choose the right stocks you need to have a good understanding of what ultimately gets growth and value stocks placed into their respective categories.
While there are no absolute rules for categorizing growth and value stocks there are some broad definitions on which most investors agree. Though there are a few stocks that fall closer to the line between these two broad definitions, most can be easily classified into one or the other.
The purpose of growth investing is to choose a stock in a growing company that has a high potential for continued growth. Value investing focuses more on purchasing stocks that are currently undervalued in the market and which therefore have a lower purchase price. These value stocks can increase significantly in value once the market makes corrections to reflect their true worth.
Growth Stocks Defined
Although investors have some varying methods for determining what makes a good growth stock, all definitions typically include the following characteristics.
• A high growth rate, both historically and projected. When you look at a growth stock’s historic performance, you need to take into consideration the size of the company that issues the stock. Smaller companies should have a historic growth rate of ten or more percent over the course of at least the last five years. Larger companies should have an historical growth rate of somewhere between five and seven percent over the same number of years.
• Projections for company growth should measure up to or exceed that of the stock’s historic performance.
• The company should have a high return on equity (ROE) measure. You should also consider comparing the company’s ROE to that of other stocks in the same industry over the course of at least a five year period. A growth stock’s ROE will rank significantly higher than average among its industry.
Value Stocks Defined
Some investors make the mistake of thinking that cheap stocks are all value stocks, when in reality a value stock can have a hefty purchase price. What makes a value stock is its placement within the current stock market – a placement which does not reflect the true value of the stock itself.
Here are a few of the commonly accepted measures for determining what makes a value stock.
• The current price earnings ratio (P/E) of the stock should be in the lowest ten percent of all companies in its industry.
• The price to earnings growth ratio (PEG) should be less than one percent, which actually indicates that the stock is undervalued. Don’t mistake this measure for insufficient growth potential.
• The company issuing the stock should hold assets which are at least twice its current liabilities and should have equity which is equal to, if not greater than, its debt.
Both growth and value stocks serve a specific purpose in your portfolio. Don’t overload your portfolio with one type or the other. Instead focus on creating an ideal balance of the two types. This will result in maximum returns with minimal risk.
Assignment:
• Identify 5 growth stocks and 5 value stocks.
• Why did you choose each stock for your list?
• Which of these stocks would you like to add to your portfolio?