Occasionally, things fall into nice, neat categories. Most of the time, though, reality is a lot more complicated. If you can think outside the box, however, you can sometimes grab investments that cross over traditional categories and offer you the most attractive features of both.
Finding value in growth
For instance, one distinction that has been given a lot of significance is the line between value and growth stocks. Many investors identify themselves as being solely in the value camp, following the traditions of great value investors like Benjamin Graham and Warren Buffett. Others look instead to companies with the potential for strong future growth in revenue and earnings, choosing to pay what some would deem excessive multiples of current earnings for stocks they hope will grow enough to justify their richer valuations. Judging by what they often say, you'd think that there's absolutely no overlap between the two camps.
The rise of exchange-traded funds (ETFs) has reinforced the idea that value and growth strategies are mutually exclusive. If you're a growth investor, you might gravitate toward ETFs like the iShares Russell 1000 Growth ETF (IWF), which counts Microsoft
Never the twain shall meet?
Yet, as you might expect, the reality isn't that simple. In fact, if you read more about exactly how Russell itself defines growth and value stocks, you find out that the index company sees a continuum rather than separate buckets. Out of the 1,000 stocks in its index of large-cap companies, Russell characterizes 350 as growth and 350 as value, and it treats the remaining 300 stocks as a combination of growth and value, including split allocations in both its growth and value indexes.
That shows how stocks might not neatly fit into either category, but it doesn't illustrate a much more important point: Stocks with good growth prospects can also be good values on a relative basis.
Tapping value in growth
For all its flaws, the PEG ratio does a good job of demonstrating the link between growth and value. Its basic assumption is simple yet important: A company that is growing at a faster rate is justified in selling at a higher multiple to its current earnings.
Really, that's just common sense. Consider two stocks, one of which has stable revenue and earnings and the other of which will double its revenue and earnings in the next five years. If each one currently earns $1 per share, it's fairly evident that the higher-growth stock should fetch a higher price. If it didn't, then once it doubles in price five years from now, either its earnings multiple would be half what it is now or the stock would have produced an outsized return.
In practice, those growth stocks tend to trade at higher earnings multiples, but they can still enjoy gains that outpace their less expensive rivals. And in fact, even though stocks like First Solar
Great companies at reasonable prices
The best investors don't let themselves get caught up in arbitrary categories. By keeping your mind open to the idea of growth stocks that offer good value, you could reap the benefits of both strategies to produce great returns for your portfolio.
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Fool contributor Dan Caplinger has been hunting bargains for weeks now. He doesn't own shares of the companies or funds mentioned in this article. First Solar is a Motley Fool Rule Breakers selection. Apple is a Motley Fool Stock Advisor pick. Microsoft and Nasdaq OMX Group are Motley Fool Inside Value selections. The Fool has written puts on Nasdaq OMX Group. Motley Fool Options has recommended a diagonal call on Microsoft and writing puts on Nasdaq OMX Group. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy couldn't be a better value for you.