As a rule, I think investors should consider tilting their portfolios towards value shares as they get closer to retirement. And this is true whether the ambition is building wealth or earning passive income.
Someone aged 40 won’t be eligible for the State Pension in the UK for another 28 years. And that means there’s plenty of time, which opens up more possibilities in terms of growth stocks.
Growth and value
Investing in the stock market’s about buying a stake in a company in the hope that it will one day make enough to provide a decent return. And there are two big differences between growth and value stocks.
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The main difference is when the company will provide that return. In general, value shares that trade at lower multiples of sales and earnings offer a much larger return in the near future.
The second difference is how much the business will provide over the long term. And in exchange for a lower short-term gain, they tend to have better prospects for generating huge returns further over time.
An investor who’s looking to retire in five years probably doesn’t have time to wait 20 or 30 years for a company to grow. But for someone with a longer time horizon, things might be different.
A UK growth stock
Halma (LSE:HLMA) is a good illustration of this. The FTSE 100 firm has a market value of £10.5bn and made £333.5m in free cash last year – a return of just over 3%.
For an investor with a shorter time horizon, this might not be so attractive. A five-year UK government bond currently comes with a 4.2% yield.
To be able to offer investors a better return than this, Halma will need to grow its free cash flow by 10% a year. And that’s far from guaranteed.
Halma generates a lot of its growth by acquiring other businesses, meaning it depends on opportunities presenting themselves. And there’s a risk they may not in a five-year period.
Long-term investing
Over 30 years however, the equation becomes much better. The corresponding bond has a 5% yield, but just 3% annual growth from the business will see Halma generate more cash.
That reduces the risk for investors. And while the firm might go through a five-year cyclical low in terms of acquisitions, I wouldn’t expect this to last until 2054.
Over the last decade, Halma’s free cash flow per share has grown by 11.5% a year on average. Even if it manages half of this going forward, this should generate enough cash to support an 8.4% annual return.
This doesn’t eliminate the risk of growing by acquisitions – there’s still a possibility of overpaying as a result of a misjudgement. But the investment equation makes much more sense over a longer timeframe and is worth considering.
No savings? No problem…
Even with no savings, using part of a monthly income to invest in shares can bring terrific returns. And growth stocks can be a great choice for investors that are thinking in decades, rather than years.
Investors need to be prepared to wait for growth to emerge. But while I think those with a short time to retirement should consider focusing on value shares, 28 years is long enough to be looking for growth.
