What is the ideal mix of companies?

There is no such thing as a universally ideal share investment, because all investors are different. In particular, different investors have different attitudes to risk, liquidity and investment horizons.

Brokers often try to help their clients choose stocks by producing lists of companies classified in various ways – for example, growth companies and value companies. However, this is not really a good way to go about it, as these are overlapping concepts.

Warren Buffett, who is regarded by many people as the world’s most astute investor, once said: “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Possibly a better way to look at investment stocks is to regard the primary classification as between growth stocks and income stocks. Other categories are, of course, also encountered – for example, speculative stocks, defensive stocks, emerging companies and so on.

Many investors very sensibly follow a strategy of diversification and as part of that go for a balance of growth and income stocks (and for a spread of shares, property and fixed income securities).

Some growth stocks are also value stocks, but so are some income stocks. Such terms are not mutually exclusive, although different analysts may choose to put a particular company in one camp or the other as though they were.

A value investor is one who typically seeks to acquire assets priced below their intrinsic worth, especially where these provide high immediate returns. Such an investor thus favours stocks with low price earnings ratios and high dividend yields and as a secondary consideration those that are cheap in relation to the net tangible asset value of the company. A value investor seeks to take advantage of the fact that the market is often inefficient in its pricing.

A growth investor focuses much more on stocks with a potential for future earnings growth and is therefore much more willing to buy stocks with high price earnings ratios and low dividend yields. Some growth investors also look for revenue growth each year, but to quote an old adage: “Turnover is vanity, profits are sanity.” The aim is to make money from a rising share price. High retained earnings help in that regard.

An income investor is one who favours stocks with a history of regular dividend payments and with the prospects that this will continue into the distant future. Ideally, the dividends will increase gradually each year and this will provide a modest growth element in the share price as well. But it is all a question of degree.

Many income stocks have low earnings volatility and strong free cash flow generation, causing them to also be regarded as good defensive stocks.

The term “value investing” is rather a misnomer, as no rational investor would set out to buy shares in a company unless these seemed to represent good value for the money. Stocks which can be regarded as both growth stocks and income stocks include the banks and property trusts.

Growth investing involves making value judgements about the business, its markets, its management and its ability to extract future earnings growth from its industry. The expected growth in the share price comes about from a combination of two factors – the growth in earnings per share each year and the gradual increase in the price earnings ratio as the market rerates the stock.

If you are interested in growth stocks with relatively low dividend yields you might like to look into Aristocrat Leisure, AXA Asia Pacific, Babcock & Brown, BHP Billington, Brambles, Computershare, James Hardie, Macquarie Bank, News Corporation, Rio Tinto, Toll Holdings and Transfield Services.

One of the ironies of the market is that stocks that are not value stocks in the sense discussed above can still show good gains if the companies concerned receive takeover bids. But there are so many of these stocks among the 2000 or so stocks listed on the stock exchange that picking them in advance is not easy.