A look at investing styles: How to pick stocks for growth, value and yield

IF you have signed up for your first brokerage account, congratulations. Your next question might be: What exactly should I buy first?

It can be a confusing choice, with many different options in the market, so let us start with the basics.

Returns from investing in stocks come from two sources:

• capital gains - when a company's share price rises above your purchase price;
• dividend income - when a company pays out a portion of its profits to shareholders.

To choose stocks that are appropriate for you, it would help to first identify your investment objectives.

Are you looking for capital preservation, and a steady income stream coming from dividends? Or do you have a larger risk appetite and want to see higher potential returns from having a stake in the next Amazon.com?

Knowing your objective helps you pick an investment style. Broadly, stocks can fit under three categories: growth, value and yield.

BT in your inbox

Start and end each day with the latest news stories and analyses delivered straight to your inbox.

Sign Up

Sign Up

Growth

As the name suggests, this investment style seeks stocks that have potential to grow rapidly. Typically, high-growth companies show high levels of innovation and an ability to scale up. This often means such stocks are found in the technology or biotechnology sectors.

Growth companies usually have products that can disrupt industries, allowing them to grow faster than their peers. But because developing new products and services is often costly, many growth companies may not be profitable.

Even if they are, it is likely that no dividends would be paid as they want to reinvest profits to capture market share and drive further growth.

This means you are investing in growth companies with the expectation that their share prices will rise as they keep growing.

The risk is that the growth company falls short of expectations. When this happens, the share prices of growth stocks may fall quite significantly.

Growth investing can be lucrative, and the Internet is full of success stories from investing in high-growth companies. But do remember that there is survivorship bias, where the less successful companies have long disappeared.

Value

Think of value stocks as stocks that are on sale.

They can be found in any sector, and are trading below what their fundamentals suggest their price should be.

How can I tell what a stock's value should be?

The two most common ratios to use for deciding value are the price-to-earnings (P/E) ratio and the price-to-book (P/B) ratio.

P/E is calculated by dividing the share price by earnings per share, and P/B by dividing the share price by book value per share.

Determining what is a high or low P/E or P/B requires a judgement call, and it is useful to compare the relevant ratios with industry peers. You can also look back at the historical averages of a company's shares and ratios to determine if the current price represents value.

Analyst reports often contain this information, but you can also look through the financial statements and do some calculations.

Investing in value stocks can provide capital gains for investors, if a stock is indeed undervalued. The assumption is that the low value is due to some temporary circumstance, and that the valuation would eventually rise back in line with peers or historical averages.

But there is also the risk of identifying false value. Markets are usually efficient, and price stocks based on the information that is available. There is usually a reason why certain stocks are cheaper than others.

When you buy goods in a supermarket, it is usually products that have defects or are close to expiry that sell for a discount.

Similarly, a company that has issues - such as poor management or unethical practices - may appear to be of good value if you only look at its price in isolation. But when the issues are taken into account, the company may not be a value stock at all.

Doing your homework and understanding a company's issues will help you identify if a stock is truly a value stock.

Yield

Yield can come from income stocks, which tend to have relatively stable share prices and pay regular dividends or distributions.

Such companies are usually mature, so most of their profits are returned to shareholders rather than reinvested into the business.

Often, they will be utility operators or real estate investment trusts (Reits). Reits are listed property portfolios, and nearly all the profits from renting out the properties are distributed to investors.

Because most of the profits are distributed, revenue and profit growth for income stocks tends to be lower and investors would be less likely to see significant capital appreciation.

It is useful to check whether a company has been generating stable earnings, and to assess if its business will allow this to continue in the long run.

Also, you should calculate the dividend yield that is being paid out (annual dividend divided by share price) and make sure that it is an acceptable rate of return for you. It may not be a good idea to invest in yield stocks if their returns barely exceed risk-free instruments such as sovereign bonds or savings accounts.

Conversely, an overly high dividend yield may also be a red flag. It would be worth finding out if there are reasons why other investors are avoiding the company.

Yield investing can be appealing to investors who prioritise preservation of their capital over growth.

Understanding the common investment styles can help identify stocks that serve your investment objectives.

Some factors to consider when choosing a style include your age, investment horizon and retirement goals. An older investor with a shorter investment time horizon may prioritise stable income. A younger investor can take on greater risk with growth or value plays, and wait longer to cash in on the capital appreciation.

Different styles can also see performance vary in line with macroeconomic trends. For most of the past decade, growth has outperformed. But when looking back over a longer horizon, MSCI data shows that value investing has been a winner.

Whatever your goals, it is useful to note that you do not need to stick solely to a single investing style. Having diversification with some allocation to each style can create a more balanced investment portfolio. This can provide potential upside from exposure to high growth sectors, while limiting the risk of losing large amounts of your capital.

• This is the second installment of Invest & Grow, a weekly 10-part series that aims to help new investors get started on their investment journey.