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Why You Should Invest in Growth, Not Value
FNArena News - September 27 2012

by Alexander Green, Investment U Chief Investment Strategist

Patrick Henry famously declared that he knew no way of judging the future but by the past.

So if you’re putting together a long-term investment portfolio, it might be wise to look at the historical returns for various types of assets. Not just for the past few years, or for several decades, but for the past couple centuries.

When you do this, you’ll notice something interesting:

  • Owning a portfolio of businesses (stocks) has generally been much more rewarding than making loans to corporations or Uncle Sam (bonds) or sticking your money in the bank (cash).
  • Look closer at the clear winner (equities) and you’ll also find that value stocks have outperformed growth stocks over the long haul and that small-cap value has beaten large-cap value by a substantial margin.

It therefore follows that an investor seeking maximum capital appreciation might focus on identifying undervalued small-cap stocks.

But there’s only one problem with this: It won’t work for most investors, even if the future is very much like the past. Here’s why…

Beware the Infamous Value Trap

Value stocks require something that growth stocks don’t: Patience.

When a stock – either large or small – is in the cellar, it’s there for a reason. Typical ones are that the company is:

  • Losing market share…
  • Seeing its margins fall…
  • Is losing money…
  • Or is experiencing flattish sales and declining profits.

As a value investor, you don’t know when this state of affairs will end, but you might be tempted to invest in a company if it’s relatively cheap in relation to sales, earnings, or book value (i.e. net worth) in the hope that management will set things right.

The problem is this can take quite a long time. Or it may never happen at all. As the stock gets cheaper and cheaper, you may believe it’s becoming an even better bargain. This is the classic “value trap.” And if you keep buying a stock on the way down, it may very well have your name on it when it hits rock bottom. 

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