Value, growth, and momentum investing are three of the most common investment strategies used by professional investors to generate returns. Some investors use a single strategy, others combine all three.
No single strategy is superior to the rest - the best strategy is the one best suited for current market conditions. One of the biggest challenges in investing is knowing which strategy to apply, and when.
Value investors are looking for underpriced assets that they can purchase at a bargain, and hold until the market better reflects what the investor believes they are worth. It is a long-term strategy in which the investor will examine the underlying fundamentals of a company, determine what it should be worth, and then compare that to the existing market price.
To determine what a company should be worth, analysts look at fundamentals like price to earnings, price to book value, and price to cash flow, then compares that to the same fundamentals from similar companies. When these numbers are lower than those found among competitors, a value investor sees a potential opportunity. They then look for any mitigating factors - reasons why a company's share prices might remain low. Once they have conducted their due diligence, they invest, and then wait.
Value investing requires time and patience - it is not for the short-term investor, as it could take a very long time for the market to realize that a value stock is a great buy. Additionally, the investor needs to be careful to distinguish between a stock that is cheap because it is undervalued, and a stock that is cheap because something is going wrong with the company.
This strategy is best suited for use during strong markets, when the economy is growing and interest rates are rising, because other investors are more likely to take a chance on underpriced companies. During market downturns, investors tend to retreat into safer investments which are already performing well, and a value investor may be left holding onto underpriced assets for longer than they can afford.
Where value investing looked for underperforming stocks that the investor believes will catch up with their peers, growth investing looks for stocks that they believe will outperform the market. It is also a long-term strategy, involving an examination of underlying fundamentals to determine whether the current price accurately reflects likely future earnings.
A growth investor looks at what sets a company apart from its competitors. Factors like ownership of key intellectual property patents, access to key markets, brand loyalty from consumers, and the ability to set prices in the industry could all contribute to enhanced performance. Instead of comparing a company to its current peers, a growth investor creates a projection of where they believe a company's fundamentals are likely to be in a few years, and then compares that to their projections of likely returns from other possible investments. If they find that a company is projected to increase its earnings at a rate faster than the rest of the market, and this is not adequately reflected in the current price, they invest and wait.
Growth investing also takes time, because the investor is relying upon future earnings reports to gradually push the price up. Another challenge comes from finding an investment that does not yet have anticipated future growth fully priced in yet, as other investors are also doing the same analysis on the same numbers.
This strategy works best under healthy market conditions, when other investors will be willing to take a chance on the small companies that are favored by growth investors.
Most investment strategies follow the old adage of "buy low, sell high", but momentum investing breaks this rule, replacing it with "buy high, sell even higher". It sounds like a very risky strategy, but has actually been borne out by studies: stocks which have outperformed in the last 12 months tend to outperform in the next 12 months as well, and at a much higher rate than stocks which had underperformed during the same time period.
Momentum investing looks at past performance, with minimal emphasis on a stock's fundamentals. While this lessened emphasis on knowledge and complicated analysis may make momentum investing appealing to non-professional investors, it is difficult to implement because of the emphasis on timing.
Although the two strategies are often conflated, momentum investing is very different from growth investing. Where a growth strategy is long-term, momentum is short-term, responding quickly to sudden unexpected price jumps. This makes it a strategy better suited for professionals than for the average investor, who may not have the ability to watch their investments closely enough for these sudden fluctuations.
Because of the emphasis on prior trends, a momentum strategy works best when markets are strong, and not flat or in decline.
What about market Downturns?
All three of the most common investment strategies work best when markets are either steady or growing. But that doesn't mean that investing is only worthwhile when markets are booming. In fact, market downturns can offer significant opportunities for savvy investors.