The following post was written by JT from MoneyMamba.com. I asked him to write several post in my recent series for beginning investors. He will provide some of the more informational pieces in this short series as I share my experience about really learning how to invest.
There is more than one way to tackle a common problem. If that problem is how to grow your money, then there are more than just a few. Let’s break down the topic of investing into different subcategories divided by investment approaches to make sense of the many different investing “styles.”
Income vs. Capital Appreciation
I like to put the first dividing line at where the investor hopes to make money. Income investors are those who want to generate an income on their investment assets, usually from regular income sources like bond or CD interest, or dividend distributions from stocks. In general, the growth in investment capital is secondary to the regular income that an investment can return to the investor. Real estate is another great example of income investing.
Other investors hope to make the bulk of their gains from capital appreciation – or rising asset prices. Here, income from the investment is less important as investors who favor capital appreciation are looking for rising investment values. Those interested in capital appreciation would be more likely to favor stocks rather than bonds or CDs.
Value vs. Growth
Within the scope of investments for capital appreciation, there are two different perspectives – value and growth.
Value investors typically favor companies that are established, and are growing more slowly, but sell for a lower relative price to faster growing stocks. Walmart would be an excellent example of a value stock today, since most of its growth has been realized. Walmart will likely continue to grow its earnings, but not to the extent that it did in the 1980s and 1990s, when it was clearly a growth stock. Because Walmart will grow slowly, investors pay only 15 times 2012 earnings for the company.
Growth investors typically favor companies that are smaller, but are growing quickly in their industry. Amazon provides a great contrast to Walmart in retail. Amazon is a young company that is growing quickly, and investors are willing to pay more for the stock today with the understanding that it will eventually grow into its higher valuation. Because investors expect Amazon’s profits to grow quickly each year, investors are willing to pay 300 times 2012 earnings for the company.
Historical evidence suggests that in the long haul, value-oriented investors tend to outperform growth-oriented investors. Simple human nature is likely at play – investors underestimate slow growing value stocks and overestimate fast growing growth stocks.
Small, Medium, and Large Stocks
One last and final division in investment approaches is in the size of the companies an investor follows. Size is determined by market capitalization, or the value of all of a company’s shares multiplied by the value of each share.
Small cap stocks – Small cap stocks are those which have a market value of $300million to $2 billion. Small capitalization stocks are generally more volatile (move up and down faster), and less liquid (it takes more time to buy or sell a lot of shares), but more rewarding in the long haul. For one, small capitalization companies have much more room to grow. It would be much, much easier for a $300 million company to double in size to $600 million than it would for a $500 billion large cap (like Apple) to double to $1 trillion.
Mid cap stocks – Mid cap stocks are those which have a value of $2-$10 billion. Mid-cap stocks are less volatile than small caps, but more volatile than large caps. In many cases, mid cap companies are just oddballs – companies that are well established in a very small market. Think Monster Beverage Corp. (MNST), which makes energy drinks. It’s a fairly large business in a very small industry: a single type of drink.
Large cap stocks – Large cap stocks are those larger than $10 billion. These are the giants of business, companies that you’re likely to read about in the news, or know people who work for them. Large cap stocks are the least volatile, but least rewarding over time. Large caps do not have substantial room to grow, and generally provide lower long run returns than small and mid cap stocks.
Picking an Approach
If you were to pick an approach solely on returns, you would choose a small cap value approach. Over time, small caps have beaten large caps, and value has beaten growth. Check out the massive difference in returns between the small cap value approach and the large cap growth approach:
Of course, it is not always that easy. Notice how small cap value stocks were more volatile than large cap growth stocks. Also notice how small cap value stocks underperformed large cap stocks from 1926-1940, a period of 15 years. While small caps outperformed large caps, going all small caps only makes sense if you have a very long time to wait out the volatility. If you don’t have the same time horizon, other styles based on large cap stocks may make more sense.