I should start off by saying that every investor is a mixture of the two. It’s like saying a team is a defensive team vs an offensive team. Every team has to play both. The designation has to do with their speciality.
There are a lot of reasons a stock’s price can go up. But generally speaking, we can fit those reasons into two broad buckets: either earnings are going up or through multiple appreciation.
A growth investor is more interested in earnings going up. He may invest in a company like Facebook (FB) with a 100 P/E. Or hell, no P/E at all because the company’s been losing money. What interests the growth investor is well… growth. So even in say 10 years when the P/E has fallen from 100 to 20, the growth investor believes that FB’s earnings will grow enough to overwhelm the multiple depreciation. That last part is important. If the PE falls from 100 to 20, then the earnings will have to go up 5 times just for the stock price to stay even. That should make intuitive sense. If the PE falls to 1/5th of 100, then earnings must grow 5 times to counter act it. Except a growth investor isn’t looking for the stock price to stay even, he’s looking for it to grow at some reasonable rate: say 8-15%.
But in order for a stock price to appreciate 15% a year, while the PE multiple is also falling from 100 to 20, then earnings would have to grow by a factor of 20 over the 10 year period. Which isn’t to say that’s impossible, just realize that you should be able to calculate the math and know what you’re getting into. (link to math spreadsheet) Turns out, that’s an annual growth rate of 35% a year.
The other way a stock’s price can go up is through multiple appreciation. The most popular multiple is the P/E ratio (link). Say a company like FOX is trading at 8 P/E and the value investor believes the company should be trading at 16 P/E. Well, if he’s right and the stock price converges to 16 P/E, then he’ll double his money just based on multiple appreciation alone.
So just to reiterate, a value investor is looking for multiple appreciation and a growth investor is looking for earnings growth. In practice, every investor is looking for those two things. Who isn’t looking for an undervalued company with high earnings potential? The difference lies in the focus.
A deep value investor would be looking for companies that have fallen out of favor with Wall Street. Or companies that have yet to gain Wall Street’s attention. (Remember, most large investment firms can’t profitably invest in micro caps because they’re too small to be worth their time.) Meanwhile, a growth investor would be looking for the next big thing.
Theoretically though, they’re both looking for the same thing: under-valued future growth. With a value investor, the future growth may be average, but the stock market is valuing it at below average or even negative. With a growth investor, the future growth may be tremendous, but the stock market is only valuing it at above average or just good.
So really, they’re two sides of the same coin in a sense.
Written in 2015