This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.
Have you ever heard the maxim "buy low and sell high"? That's value investing. Buy a dollar for $0.50, hold it, and then sell it for $1 or more. Growth investing is different. Instead of searching for discounts, growth investors are happy paying $1 for the chance of earning $10 from that same bet years down the road.
What growth investing is
The difference is a matter of nuance, I realize, which is why Warren Buffett has famously quipped that value and growth are joined at the hip. Each philosophy seeks market-beating returns. Each seeks underpriced businesses.
Where value and growth investors usually diverge is in the types of businesses they feel comfortable owning and the amount of risk they're willing to absorb in the quest for higher returns. Time can also sometimes be a factor.
Value hunters are most comfortable owning businesses that are numerically cheap. Think of Wells Fargo (NYSE: WFC), a massive regional bank whose price-to-earnings ratio comes in at about 10. With the average stock in the S&P 500 carrying a P/E of around 14, Wells Fargo is undeniably cheap by the numbers.
By contrast, a growth investor may be more interested in Zipcar (Nasdaq: ZIP). The car-sharing service is at the beginning stages of rolling out nationally, and while it isn't yet profitable, revenue is up more than 40% over the past year. All signs point to a geometrically expanding market opportunity. But with the company posting net losses and therefore having no P/E ratio, Zipcar is undeniably expensive by the numbers.
Who invests this way?
Owning Zipcar is riskier. It may also take longer to realize a return since few investors are willing to take a chance buying an unprofitable company.
In this sense, growth investors are much like venture capitalists. Fool co-founder David Gardner has compared his own style of high-growth investing -- a strategy codified in a service we call Motley Fool Rule Breakers -- to that of a VC. He's willing to pay up for high-growth businesses because very often they're the best in their markets, extraordinary value creators that almost never trade for a numerically cheap price.
Is it for you?
Therein lies the difficulty with buying growth. Paying a premium can lead to overpaying, and overpaying can lead to disaster. Just ask anyone who thought tech stocks were cheap at the height of the dot-com bubble in the early 2000s.
How to know if you're overpaying? There's no sure answer, but David has identified six signs of a successful high-growth investment. The benefit of owning these "Rule Breakers" is that they can multiply in value -- from $1 to $10 rather than just $0.50 to $1.
Think of Baidu (Nasdaq: BIDU), the Chinese search engine that found favor with locals and which was built to serve a fast-growing, numerically massive Internet population. Huge revenue and earnings growth was all but assured, and equally huge stock returns followed. Investors who bought when my colleague Rick Munarriz first recommended Baidu are up more than 1,600% over a period during which the S&P 500 is down more than 10%.
Less risky than you think
I'd argue for adding at least a little growth to your portfolio, even if the value style appeals more to your taste and temperament. (Most people feel this way, and for good reason. Value is a tested, risk-averse strategy.)
Why? Because the growth can do more with less. All it takes is one big winner to overcome a surprising number of losers. It's for this very reason I named Qlik Technologies (Nasdaq: QLIK), a stock with a P/E ratio north of 500, as my top tech stock for 2011. I personally own shares as well.
I'm not worried about the results. Not only do I believe in QlikTech, but the risk of owning a stock that could go to zero is muted in a balanced portfolio. Consider: Six stocks on the Rule Breakers scorecard had lost more than 80% of their value by the time we sold, yet our aggregate performance -- achieved by investing in great, high-growth businesses -- ranks among the very best of the newsletters tracked by the Hulbert Financial Digest.
The Foolish bottom line
Please don't take that as an advertisement for Rule Breakers. All I mean to suggest to you is that growth is a viable, if volatile strategy. Mixed together with healthy dollops of dividends and deep value choices, high-growth stocks can be just the catalyst your portfolio needs to edge the market averages. In the end, that's all that matters, right?
Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.
