Saturday, 1 April 2017

Growth vs Income Investing - A little snapshot

I was thinking of what to write about today and I chose this topic as I believe that this is one question common to many new investors including myself. 😁

Growth stocks

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There are many ways to define growth, but in this case let's define growth of a company to be an increase in the company's earnings per share. Which can happen in two broad ways:

1. Increase in earnings per share (Commonly abbreviated as EPS) from their usual operations (this is also called organic growth sometimes)
2. Increase in earnings per share from inorganic (or acquisitive growth); basically growing by buying up other companies*

(* you may be wondering, how can a company increase earnings per share by buying over another company. That is a very good question. Even though sometimes companies buy up smaller companies by paying the owners of the latter companies with shares, causing a dilution in earnings per share, however, by combining forces, companies can sometimes achieve "synergies" (=cost savings), and even perhaps allow greater access to markets they have been eyeing which ultimately increases revenue and profit)

With EPS growth, share price generally follows. This is because the company of interest would appear to be cheaper once its financial statements containing the growth in earning is reported.

This then results in metrics such as P/E (price to earnings ratio) and EV/EBITA (enterprise value to [earnings before interest, tax, depreciation and amortisation]) which measures how cheap a stock is, looking more favourable. Investors then flock to the (literally) cheaper shares, pushing up share prices, until buying and selling equilibrates.

This all sounds great doesn't it? So what are the downsides?

Well for one, growth companies are often relatively smaller (we're talking both about organisation size as well as market capitalisation here). It is arguably more likely that a company with a small market capitalisation (maybe in the Low- mid millions) can grow, or rather increase shareholder value than a large corporation worth billions*.

[*Some reasons why:
- because organic growth is harder to achieve for large companies as there are often already many consumers of their product, and there is market saturation
- Because mergers and acquisitions between large companies are often more tightly regulated by the authorities, to prevent a monopoly which in theory can cause complacency and inefficiency]

The flipside, as you may already have guessed is that small companies often bear higher risks and may more often be speculative in nature. Larger companies tend to have a longer track record, have a better organisational structure, and have more experienced management teams, which more often than not are absent from small companies.

Bear in mind that there are always exceptions to this, for example, a large company (in terms of market capitalisation) could have just experienced a rapid increase in share price due to a sudden event leading to an increase in demand, and in this case, the company as well as its management may not have had a longstanding track record.

Hence, proper and in-depth research is also necessary to determine whether or not a company has a good record, or whether it has purely been benefitting from tailwinds.

Income stocks (often, but not always blue chip shares)

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Stable-Income paying companies are often not growing as much, relative to the growth companies that is. Most of these companies are industry behemoths and instead of reinvesting earnings for growth to generate value for shareholders, earnings are mainly returned to shareholders, probably because management has decided that it is the better option to do so (due to size and product saturation etc as I've mentioned earlier which limits growth).

This has its pros and cons as well.

Even though history doesn't indicate the future, but it's arguably somewhat suggestive of the future. A 10 billion dollar company with lots of assets and infrastructure and an experienced management team that has been paying dividends consistently in the past 20 years would be more likely than not still be able to continue paying its next/upcoming dividend, right? Which is why I love income stocks; because of its relative stability.

Relative's the word, and the stability is not a given. I'll once again reiterate, they are more likely to be able to remain stable and continue paying dividends, but the converse can possibly happen as well, although the chances are somewhat smaller.

Noble group is one notable example (even though not a great example for picture I've just painted as it does not have a Long and consistent dividend history), and for the benefit of the readers who have not heard of it; basically noble was a blue chip share that was removed from the index this year due to many issues affecting it.

So what's the conclusion?

Before we go to that, lets first go through a hypothetical scenario:

A large income stock with a 6% annual yield would have yielded 60% of your initial investment after 10 years (assuming no reinvestment of dividends in shares).

On the other hand, a small cap growth company with a dividend of just 2% can potentially provide a 5.18% yield on the initial investment amount after 10 years, assuming a 10% annual dividend growth, which is equivalent to the levels of many income paying stocks. With capital gain to boot (which may be more than 60% if income were to grow for >10 years as investors will often push prices up before any financial results if they already expect the company to continue growing), they can potentially overshadow income stocks.

Personally I believe that there is no good reason to fully focus on either small cap growth stocks Nor large income stocks. The mix between them is subjective and also depends on the targets you have set for yourself. I do prefer growth stocks over income stocks as I am investing mainly for the Long term.

Thank you for reading, and I would be happy to hear any opinions on this 😁.

Best Regards,
A 😁

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