JEDDAH, 24 July 2006 — Just as there are different schools of painting, there are different schools of investment strategies: growth, value and nonbelievers.
For an investor to build a portfolio one has to start with a basic premise. Does one built a portfolio believing in growth thesis or value or is one a nonbeliever in either growth or value. If one looks at the Tadawul All-Share Index (TASI) and conducts research to put together a portfolio, it seems there are various alternatives. However, one has to keep in mind the objective of the portfolio and its long-term goals. One should not be carried away from the underlying investment objectives and compromise for immediate gains and gratifications.
Identifying Growth Stock Can Be Difficult
Growth stock believers argue that you want to own stocks in companies whose earnings and dividends are constantly increasing. These companies tend to have excellent management, proprietary positions in businesses and are not particularly cyclically sensitive, and most likely highly profitable. In an ideal situation, growth stock investors want to hold shares in great businesses, and sell only when the business itself falters, not because the price of the shares has increased.
The problem is no one has perfect foresight. It seems we are always overconfident and overoptimistic about our skill in identifying growth companies. Growth stock investors usually fall in love with their growth companies that have treated them well. Remember you are buying stocks, not companies and don’t fall in this love trap. Sell growth stocks when they become outrageously expensive. Fall in love with people, children and cats, but not stocks.
So when you are researching for a growth stock in the TASI, look for a share in business enterprise which has demonstrated long-term growth of earnings, reaching a new high per share at the peak of each subsequent major business cycle and which after careful research, gives indications of continuing growth from one business cycle to the next at a rate faster than the rise in the cost of living.
Value Investors Love Ugly Companies
By contrast value investors want to own stocks that are cheap not only in relation to other equities but also in absolute terms. They want three U’s: Underowned, Unloved, and Undervalued. Of course the choice would rather be to buy a well-managed, good business at a depressed price, but such situations are few and far between. Instead they buy stocks that can be purchased well below their intrinsic replacement-cost value as a business, where current profits are beneath their sustainable earning power of the company, and that are also cheap by the traditional measures of value.
Value investors definitely don’t fall in love with their stocks. When the price of the shares of the ugly companies they own go up, become expensive, and sell well above their intrinsic value, value investors sell them and go searching for cheapness elsewhere. Value stocks, by definition, are cheap in relation to their assets and earning powers because investors are pessimistic about them. There is usually bad news associated with them, and since investors tend to be extrapolatory, they assume the bad news will continue.
Nonbelievers Believe This Too Shall Pass
Nonbelievers don’t believe in either religion. They say everything in the investment business is temporary. When growth stocks are relatively cheap and the economic environment favors them, they own growth stocks. When value is cheap and growth is expensive, they will look for value. Hard-core growth and value investors believe that switching back and forth is a loser’s game.
Now as you research the TASI and build your portfolio you decide what thesis you want to follow, importantly make sure you understand the reasons to choose whichever path you have decided to pursue.
(Faisal Alsayrafi is president & CEO of Financial Transaction House.)
