Growth investing is a strategy that focuses primarily on investing in companies with significant growth in the future. Such businesses are often characterised by solid revenue and earnings growth, and higher multiples. While following growth investing can be a profitable strategy, it typically carries a higher level of risk relative to other strategies because growth stocks tend to be more volatile; that is, their prices fluctuate rapidly in response to changes in the macro environment or market conditions or company performance.
Value investing is a strategy that prioritises identifying businesses that are undervalued by the market. That is investing in businesses that are trading at a discount to their intrinsic value, which can be determined at a reasonable level by analysing various factors such as financial statements, market trends, and economic indicators. Investors following the value strategy typically look for companies with strong fundamentals, low price-to-earnings (P/E) ratio, high dividend yield, or low price-to-book (P/B) ratio.
These metrics suggest that a company's stock trades at a discount to its fair value, making it an attractive investment opportunity. Common characteristics of companies falling under the value category include a strong balance sheet, a history of stable earnings, and a competitive advantage in their respective industry.
While value investing is a profitable strategy, there are cases where companies may be trading at low multiples appearing as if the stock is trading at a discount, however it may be justified because these companies may face challenges or have weaker growth prospects than their peers, making them riskier investments.
Investors following either of the strategies have been profitable, and each strategy works well on different occasions. For example, value stocks are likely to outperform during bear markets, economic recessions and expectations of a slowdown in the economy, while growth stocks usually excel during bull markets or in periods of economic expansion cycles.
While growth stocks have the potential to grow at a rate significantly above the market, they have wavered recently due to a persistently high inflation environment, rising interest rates across most economies and a fear of a slowdown in advanced economies.
Growth investing and value investing are diametric approaches where value investors look for companies that trade below their intrinsic value or book value and growth investors look for companies that appear overvalued but have the potential to grow at a rate superior to peers or industry. In order to overcome the shortcomings of both investing styles, investors can look to follow growth investing through valuation filters that combine the best of both worlds.
Growth at reasonable valuation (GARV) is a fundamental-driven investment strategy that balances growth and tends to invest in high-growth, yet expensive stocks and value stocks that are trading at a discount to the fair value.
Primarily, the GARV strategy favours investing in companies with consistent earnings and sales growth, reasonable valuation, and solid financial strength. The underlying investment thesis is to earn higher risk-adjusted returns than its underlying universe over a long-term investment horizon.
GARV’S multibagger framework
3 Year Net Sales growth
3 Year Earnings growth
Note: The table is for illustrative purposes only
Earning growth + Multiple re-rating = Wealth creation
- Data is used for illustrative purposes
- Earnings growth is Normalised for covid impact
The table above shows us how the multi-bagger framework and GARV strategy come together to create wealth. Earnings growth and multiple re-ratings over time due to businesses with strong fundamentals and solid growth lead to a higher degree of price appreciation.
To identify such businesses, investors can look at metrics like the three-year net sales and earnings growth which capture a company’s growth, and in order to sustain the growth momentum, the company needs to be highly profitable, indicated by a consistently high ROE and the company must not have excessive leverage (permissible range for the ratio varies depending on the sector).
For relatively reasonable valuation, investors can look at PE, EV/EBITDA, earnings yield and industry-specific multiples. These factors, along with others, effectively capture the characteristics of the GARV strategy and balance between growth and valuation exposures and lead to better long-term risk-adjusted returns.
Prabhat Ranjan and Vijay Chauhan, Co-Fund Managers at Right Horizons PMS.