You likely identify yourself as either a value investor or a growth investor. These two investing camps often seem at odds with each other, sometimes even resembling the bifurcation of our political parties.
So which approach takes the cake as the best investing strategy? First let's define our terms.
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What is value investing?
Value investing focuses on finding quality businesses that are trading below fair value. Warren Buffet has famously described it as buying a dollar for $0.60.
As you would expect, valuation metrics and models such as the price-to-earnings ratio or the discounted cash flow model are vital tools for the value approach.
What is growth investing?
As its name suggests, growth investing focuses on buying companies in the earlier stage of their life cycle that are poised for high growth (usually 15% or higher) for many years to come. These are usually, but not always, disruptive technology companies that tend to trade at high valuations due to the fact that they are investing heavily to grow the business instead of realizing profits.
A better way to think about growth vs. value
From a valuation perspective, these two investing strategies appear to be polar opposites. But I believe there is a better way to think about the two approaches that make it easier to add both growth and value companies to your portfolio.
Instead of thinking in the terms growth vs. value use predictability and optionality.
Predictability
When trying to value a business, investors benefit from being able to forecast a company's future growth. In order to do that with any degree of accuracy, you need a well established business with a track record of years if not decades. While the past is never a guarantee of the future, a consistent track record gives investors higher confidence when predicting future growth.
A classic example of a more predictable business is Ball Corporation (BLL 1.37%). The manufacturer of cans and jars has grown its earnings by an average of 10% per year for the last 12 years, resulting in its stock returning over 700% during that period. Businesses like these might not always be the most exciting, but every balanced portfolio needs a handful of predictable companies for consistent compounding.
Optionality
The upside for growth stocks is hard to model. Imagine accounting for Amazon's (AMZN 0.21%) AWS cloud division in a discounted cash flow model back in 1998. There's no way you could have predicted that. What you're actually paying for with these stocks is optionality. Amazon investor's in 1998 were buying a disruptive online bookstore, but for those with the tenacity to hold their shares, they ended up with a global leader in e-commerce, cloud computing, streaming, and logistics.
Stocks like Amazon are obviously very rare and growth stocks are inherently more volatile, so it's smart to spread your bets across quite a few high optionality companies. You only need one winner to skyrocket your portfolio.
A current day example of high optionality is a company like UiPath (PATH +0.00%). This company, which came public in April of 2021, provides robotic process automation (RPA) software to businesses across a diverse set of industries. As automation continues to grow bigger by the year, this leader in RPA could be at the center of disrupting the way we think about work.
Best of both worlds
Every so often you come across a company that exhibits both predictability and optionality. A present day example is Tesla (TSLA +7.57%). While no one will call the EV leader a value stock at a price-to-earnings ratio of nearly 200, the company has a fairly established core auto business with tons of optionality baked in: AI, robotics, robotaxis, trucking, solar and perhaps their most underrated "product" -- their gigafactories.
Companies like this that have both an established core business while also investing aggressively into new products and markets offer both resilience and the possibility of asymmetric gains.
Bottom line
Limiting yourself to investing in only growth or value stocks is doing your portfolio a disservice. Once you realize these companies serve different purposes in your portfolio, you'll see the smartest strategy is to own both. A handful of predictable businesses can give your portfolio a solid foundation, while a large number of small bets spread across high optionality companies exposes you to potential disproportionate gains.
