MARCH 2007 :: CONSUMER ED

The Styles of Wall Street
Three Types of Investors, and How They Sort Out Their Socks

Shoppers have their own styles. There are those who pay full price for brand-name products with proven quality. Then there are those who scour the bargain bins and clearance racks, hoping to snag a deal on a gem that others have overlooked. And some do a little bit of both.

›Adapted from "The Wall Street Journal Complete Personal Finance Guidebook," by Jeff D. Opdyke. Copyright 2006 by Dow Jones & Co. Published by Three Rivers Press, an imprint of the Crown Publishing Group, a division of Random House.

Investors have different styles, too. Some investors lean toward stocks of companies that have a strong record of fast-growing profits. These people are called “growth” investors. Others go for stocks that appear to be bargains, with a lower market price than what the financial prospects of the company, or its assets, would indicate. They are “value” investors.

In terms of making money on your investments, the style you choose may not be as important as the specific companies you choose. Both strategies require you to carefully study the numbers behind the companies, but growth investors tend to concentrate on different sets of numbers than value investors.

‘Above Average’

Growth investing emphasizes revenue and earnings that are growing quickly and consistently, and are well above average, so these investors look to the company’s quarterly income statements for clues. Revenue (or sales), the top-line number on a company’s income statement, is all the money a company generates selling whatever it sells. Earnings (or profits), the bottom-line number, is all the money that’s left over from revenues after paying salaries, production costs, taxes and such.

What defines “well above average” depends on the company and the industry. For an upstart technology company, above average might mean earnings growth of 50% to 60% a year. For a sedate grocery-store chain, above average might be earnings growth of 15% a year.

Growth investors commonly “pay up” for the stocks of companies they consider to be growth investments. That means that as long as a company is growing at a rapid pace, investors willingly pay what others might consider a high price to own the shares. For them, the initial stock price is secondary to the potential for earnings growth. As such, growth stocks often sport higher-than-average price/earnings, or P/E, ratios.

Take, for instance, Cisco Systems, which at one point in late 2000 traded at a P/E multiple of up near 160, as growth investors bet that technology and the Internet would revolutionize the fabric of everyday life.

While that certainly has happened, you can’t escape the risks inherent in growth-stock investing. Growth stocks are often “priced for perfection,” meaning that as long as they continue to deliver the fast-growing sales and earnings, investors will continue to want the stock, supporting the share’s high price. But as soon as the helium starts to leak from the balloon, watch out. Even if a company’s growth slows to 45% from 50%—still considered a very rapid clip—investors will punish the stock price as they rush to flee what they suddenly see as a sinking ship.

Indeed, after 11 years of pleasing Wall Street, Cisco in early 2001 missed its earnings estimates for the first time ever—by exactly one penny per share. Revenue growth, meanwhile, slowed to 40% from expectations of 55%. Investors clobbered the stock. Cisco shares ultimately slid all the way into the single digits at one point.

Bargain Basement

Value investing is like the old blue-light special at Kmart, where merchandise is suddenly on sale.

Value investors buy stocks at prices that they believe underestimate a company’s true profit potential or undervalue its known assets—in other words, bargain-basement investing. These stocks typically trade at a relatively low P/E ratio, often in the single digits or in the range of 10 to 15. They trade that low because the majority of investors feel a company’s earnings potential is limited or maybe they’re concerned about some problems the company has or is expected to have.

Value investors look at stocks in terms of their “relative valuation” or how they currently trade in relation to their history, their competitors, and the market as a whole. The yardsticks most commonly used are P/E ratio and measures that look at the price in relation to a company’s cash flow and sales.

Eastman Kodak is one example of value investing at work. Once a growth stock, Kodak fell from grace in 2001 as it faced increasing pressure from rival Fuji Film and the rise of digital imaging. Kodak’s shares, above $90 in the late 1990s, tumbled into the low $20s by 2003. At that point, value investors began snapping up the stock, confident that Kodak’s business, while certainly changing, wasn’t dead. The shares began to rebound—into the mid $30s in early 2005—as the prognosis for Kodak’s survival improved.

Of course, the risk with value investing is that what looks like a bargain might just be junk. Bethlehem Steel was once a fallen angel that many value investors bought at hugely depressed levels of just a few dollars a share. Yet the company fell into bankruptcy, and now the shares trade only among collectors of old stock certificates.

Historically, value investing beats growth investing over the long haul, though in shorter periods growth often wins. The reason is that value investing done right has a built-in margin of safety, in that the real value of the stock an investor buys is generally more than—or at least much closer to—the purchase price. Growth investing typically doesn’t provide that safety margin. While growth dishes up big gains over shorter spans, companies simply cannot sustain above-average growth rates for very long.

The Big Picture

Growth and value investors, despite their differences, are at heart fundamental investors. In other words, they examine a company’s financial fundamentals to determine whether they think a stock is a buy or a sell. But there’s a third category of investors who don’t care about the financial performance of companies, or even their names. For them, it’s all about pictures and patterns. These investors are “technicians,” and they are some of the least understood investment pros on Wall Street.

Technicians don’t look at individual statistics on a stock, but at charts and graphs, searching out patterns that, they argue, portend a stock’s future. They look for “rounded tops,” “head and shoulder” formations and other shapes in a stock’s daily, weekly, monthly, and yearly pricing charts. Many technicians don’t even know the companies behind the stock symbols they trade. As long as a particular pattern is evident, they’ve got enough to make their trading decisions. That’s why some fundamental investors view technicians as Wall Street’s version of carnival fortune-tellers.