There are many different ways to invest in the stock market -- day trading, growth investing, and value investing, to name a few. Which is the best method? If you want to gamble, become a day trader. If you are serious about investing your money in a disciplined fashion, consider value investing or growth investing. Or, why not take the best of both worlds? After all, that's what the world's greatest investor, Warren Buffett, has done.
What is value investing?
Broadly defined, value investing means buying a stock at a discount to its intrinsic value, or the fair value of the business. The tough part is the process of valuing a company. How do you value brand power, competitive advantages, customer loyalty, growth opportunities, or a spectacular CEO? You don't. At least that's what the hard-core value investors choose to do. They focus on asset plays, a strategy in which investors buy companies at a discount to the value of their tangible assets.
Case in point: Bank of America (NYSE:BAC). Historically, banks trade substantially higher than book value. Banks trading below book value is a new phenomenon. In recent history, it wasn't until 2008 that Bank of America dipped -- excuse me, plunged -- below book value. To this day, the company trades at just 0.6 times book value while the rest of the industry, on average, trades at book value.
I happen to agree that Bank of America is undervalued, believing the company has significant growth prospects. But this isn't always the case. Sometimes companies trade below book value and also suffer the unfortunate circumstances of a declining industry. In these cases, traditional value investing won't do you any good.
What is growth investing?
In growth investing, investors throw out valuation altogether. They look for excellent businesses with outstanding long-term growth prospects, investing on the premise that excellent businesses, over time, will outgrow their premium valuations. There are some good traits to growth investing, but it's too simplistic; valuation might not always matter, but most of the time it does.
Combining value investing with growth investing
When value investing and growth investing are combined, investors look for reasonably priced, excellent companies to hold for the long haul. In this case, valuation is a concern, but investors don't need to quibble over a few dollars. It turns out that it's tough to buy excellent businesses at prices that seem undervalued anyway, so this opens the door to plenty of new opportunities.
Baidu makes a great example. The company may trade at 17.5 times earnings and seven times book value, but its leadership in online search and digital advertising in China gives the company significant growth opportunities over the long haul.
The Warren Buffett Way
Combining value investing with growth investing allows investors to choose among top-notch businesses, buy at reasonable prices, and avoid the major volatility of strict growth investing. It may sound Motley, but it's an excellent way to invest. Don't take my word for it; take it from Warren Buffett: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends Baidu. The Motley Fool owns shares of Baidu and Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.