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As a general rule, I think investors should consider tilting their portfolios toward value stocks as they approach retirement. And this is true whether the ambition is to build wealth or earn passive income.
A 40-year-old will not be able to receive the state pension in the UK for 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 involves buying a stake in a company with the hope that one day it will earn enough to provide a decent return. And there are two big differences between growth stocks and value stocks.
The main difference is when the company will provide that refund. In general, value stocks that trade at lower multiples of sales and earnings offer much higher returns in the near future.
The second difference is how much the company will provide in the long term. And in exchange for less short-term profit, they tend to have better prospects for generating huge returns over time.
An investor who intends 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 could be different.
A UK growth stock
Halma (LSE:HLMA) is a good example of this. He FTSE 100 The company has a market value of £10.5bn and earned £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 as attractive. A five-year British government bond currently yields 4.2%.
In order to offer investors a better return than this, Halma will need to increase its free cash flow by 10% per year. And that is far from guaranteed.
Halma generates much of its growth by acquiring other businesses, meaning it depends on opportunities that arise. And there is a risk that they will not do so within five years.
Long term investment
However, after 30 years, the equation gets much better. The corresponding bond has a 5% yield, but only 3% annual growth in the business will make Halma generate more cash.
That reduces risk for investors. And while the company could go through a five-year cyclical low in terms of acquisitions, I wouldn't expect this to last until 2054.
Over the past decade, Halma's free cash flow per share has grown 11.5% annually on average. Even if you manage half of this going forward, you should generate enough cash to support an 8.4% annual return.
This does not eliminate the risk of growing through acquisitions; There is still the possibility of overpaying as a result of a miscalculation. But the investment equation makes a lot more sense over a longer period of time and is worth considering.
No savings? No problem…
Even without savings, using part of your monthly income to invest in stocks can generate fantastic returns. And growth stocks can be a great choice for investors who think in decades, rather than years.
Investors should be prepared to wait for growth to emerge. But while I think those with little time left until retirement should consider focusing on value stocks, 28 years is plenty of time to look for growth.
