There is merit in staying with ETFs (Exchange-Traded Fund) for individuals investing in the stock market. The fees are low and you are guaranteed an index’s return; something many individual investors and mutual funds undershoot.

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If you decide you would like to invest in individual stocks (because you want to try to beat the index, or you prefer more control), there are several choices for evaluating stocks. There are many investors that believe technical analysis (buying and selling stocks based on a company’s price and volume fluctuations) is the best option.

Many studies, however, find that it is difficult to beat an index with a technical approach. For instance, a comprehensive 2003 study by Amsterdam economist Gerwin Griffioen found that technical trading did not beat the market of the long-term. The other major branch of investing is fundamental analysis, which analyzes a company’s financial statements, management, competitive advantages, and sector. The two main branches of fundamental analysis are value and growth investing. This article will explore these two branches.

Some of the 20th century’s greatest investors have something in common: Ben Graham, Warren Buffett, John Templeton, John Neff, David Dreman, and Marty Whitman are all value investors. Value investing means different things to different people, but Warren Buffett distilled the definition well in his 1992 Berkshire annual report: “What is investing if not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can be sold at a still higher price — should be labeled speculation (which is neither illegal, immoral nor — in our view — financially fattening.)”

So, a value investor buys a company because he believes it is intrinsically worth more than what the market is asking for it. A growth investor, by contrast, may think that a stock is currently fairly valued by the market, but he expects the company’s future growth to drive the market price upward. A value investor looks at a company’s growth too, but he is unwilling to overpay for it.

The easiest way to gauge a company’s value is to look at its price to earnings ratio (P/E). You can compare it to the sector, or competitors, and get a sense for value. I prefer looking at free cash flow (FCF) and the price to FCF ratio (P/FCF). FCF is the figure you get by subtracting capital expenditures — such as the sum a company might lay out to acquire new machinery — from the cash it has taken in from business operations. Wall Street tends to focus solely on earnings. P/FCF can be similarly compared to competitors and sectors. I find FCF is a more helpful number because earnings can be clouded by accounting gimmicks. It is much harder to manipulate the bottom line in FCF.

The key skill set for growth and value investing is the ability to estimate the true value of a business, including its future FCF. Unfortunately, there is no precise science to estimating the likely cash flow profitability of a business. That is why most value investors prefer to have a substantial margin of safety when buying shares. For instance, if an investor deems a company’s value to be $10 a share, he may not want to purchase for more than $5 a share, giving him a 50% margin of safety. A growth investor doesn’t look for margin of safety, because he expects future growth to dwarf the current price, regardless of the present value of the company.

A value investor shouldn’t give up on FCF growth, but he should try to pay a sensible price for it. When I create a value analysis for a company, I generally use a conservative growth forecast. If a company has had average FCF growth of 25% over the past five years, I will run scenarios with future five year growth at perhaps 12% and 5% to see if there is a significant margin of safety if growth slows. Unexpected events happen to even the most stable companies; don’t invest with only the best case scenario in mind.

If you’re interested in picking stocks, there are lots of avenues to follow. I recommend following the value investing path laid down by Graham and Buffett. Look for excellent companies, but only at prices that offer you a significant margin of safety. Growth is great, but don’t overpay for it. I expect a diversified portfolio of solid value stocks to significantly outperform a similar growth portfolio over the next five years.

One way to compare the long-term returns of growth and value stocks is to use the Russell 3000 growth and value indexes. Each of these indexes reflects the performance of the 3,000 largest growth or value stocks trading in the marketplace. From August 7, 2000 to November 12, 2012, value outperformed growth significantly: 24.94% to -23.91%.

Aram Durphy is portfolio manager and principal of Liberty Hill Investing, an independent investment advisory in San Francisco, CA. He specializes in value analysis of stocks and bonds, with a market-beating long-term performance track record.

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