Evergreen | Growing Capital
For a winning portfolio, don’t just think growth vs. value
What is the Soundest Investment Approach? Felix Narhi writes about growth vs. value for The Globe & Mail
Putting the Growth vs. Value Investing Debate in Perspective I often get asked the question, “Are you a value investor or a growth investor?” When asked that way I find that it is usually loaded with a predefined understanding about the two most popular investment styles. Growth vs. value, while they both address important aspects of sound investing, I believe they are, in fact, connected. I am a value investor. After all, who wants to pay more than the value they are receiving in return? It is clear that fast growing companies are usually worth more than their slower counterparts, but fast growers should still only be bought when they are undervalued. When expressed that way, isn’t all intelligent investing value investing? Nevertheless, it remains customary to treat them as separate investment approaches. Let’s consider the conventional definitions.
- Value investing is thought to be the purchase of “cheap stocks” which is often characterised by statistically low price-to-book, low price-to-earnings or high dividend yield ratios. Value investors prefer to slowly and steadily build a portfolio of cheap stocks of average quality businesses and sell them as they appreciate to fair value, repeating the process over time as they cycle through constant new opportunities.
- Growth investing is thought to be the purchase of fast or consistently growing companies at fair prices. Growth investors typically like owning growing businesses bought at reasonable prices and holding them for a long period of time.
Investors are typically expected to be in one of these camps and many consider it almost intellectual heresy to consider opportunities that fall into the other side of this philosophical divide. While these long-held distinctions have the advantage of being familiar concepts to investors, they can be misleading and cause muddled thinking. Unfortunately neither camp is entirely adequate on its own.
The main purpose of investing is to put out money today with the prospect of receiving more money back in the future. In other words, the act of investing involves reducing some consumption today in order to have the ability to consume more at some point in the future. Investors are faced with an important question: How can I compound my capital to have more money down the road?
Both the “value” and “growth” approaches will fail to produce an adequate return if an investor pays a price that is higher than the intrinsic value of the business. After all, no matter how fast it grows, no business is worth an infinite price. Even so-called cheap stocks will produce poor returns if the business value erodes further over time or management makes value destroying decisions. The key to intelligent investing is to obtain value that is at least sufficient to justify the amount paid for it: If you obtain more value than you are paying for, you will have better odds of obtaining a decent return, or better. If you obtain less value than you are paying for, you will likely generate a subpar return. Herein lies the issue with traditional “growth vs value” definitions – neither side truly focuses on the all-important intrinsic-value-to-price-paid equation in a holistic way. Neither statistical cheapness nor strong growth are tickets to investment nirvana alone.
Intrinsic value can be defined simply as the discounted value of the cash that can be taken out of a business during its remaining life. Enterprising investors attempt to search for discrepancies between their estimate of the intrinsic value of a business and the price of that business in the market – the larger the difference between the two, the greater the margin of safety and potential returns.
When estimating a company’s future cash flows, growth, or lack of growth, is one of the most important factors that needs to be considered when assessing value. For example, a business that can steadily grow intrinsic value at 10% will usually be worth more than business that is growing its value at 3%, all things being equal. However, buying the business growing at 3% may provide a better return if the difference between its intrinsic value and price is wider than the former.
Things are rarely equal. “Growth” investors sometimes fail to appreciate that not all growth creates value or that relatively few businesses can grow at high enough rates for sufficiently long periods to justify their often lofty valuations necessary to deliver above average returns. Investors that were lured into the tech mania of the late 1990s and resource mania of the mid-2000s can attest to the downside of both “bad growth” and the dangers of paying a price that was too high relative to intrinsic value, despite the fast growth.
Conversely, “Value” investors often get enticed by cheap statistical metrics and get stuck in so-called “value traps”, or those situations where business value slowly erodes over time where the “cheap” looking stock was actually proven to have been expensive as time moves forward. There are plenty of businesses that are today’s equivalent of the “buggy whip factory” of yesteryear which will generate subpar returns for their investors despite looking very cheap. One needs to be alert for trends that can mess up an investee’s business models and erode its intrinsic value. Investors need to keep in mind that it is hard to obtain a return that is better over the long run than what is generated by the underlying business itself.
Estimating the intrinsic value of a business is no simple task and will never be a precise figure. It requires assessing an unknowable future which has a wide range of possible outcomes. As a result, it is appropriate to think about intrinsic value in dynamic range-based estimates, which will vary over time, rather than a static “target price”. It also requires evaluating a management team’s ability to intelligently deploy the cash that is generated by a business.
Although there are never any guarantees, some businesses are clearly more predictable than others. For instance, a regulated utility usually has a far more predictable future than a junior mining exploration company. So, it is easier to estimate the intrinsic value range of the former than the latter. And there are times when intrinsic value will be virtually impossible to estimate. Prudent investors should avoid putting capital at risk in those stocks when they are unable to assess what value they are getting in return. The line between speculation and investing will always be somewhat blurred when investing, but putting capital at risk without any fundamental basis for valuation is just gambling and best saved for a casino.
Practitioners of traditional value investing would likely protest that it is very hard to predict growth and therefore it is more conservative to assume no or very limited growth. Practitioners of traditional growth investing will likely protest that fast growth more than makes up for the high prices paid. Yet, both sides have significant blind spots and could learn a little from the other. The price-to-intrinsic value approach is not an easy approach. Far from it. But neither is any other approach. Nevertheless, buying businesses below their conservatively estimated intrinsic value represents a sound and rational approach that better reflects the reality of business analysis and investing.
Ironically, Ben Graham, who is usually recognized as the “father” of value investing, apparently never actually used the phrase, “value investing”. The term was coined later to help describe his ideas and has led to significant misinterpretation of his principles. Graham wrote a widely acclaimed book entitled, “The Intelligent Investor” which Warren Buffett called by far the best book on investing ever written. To Graham, intelligent investors need to use discipline, research, and analytical ability to make often unpopular but sound investments in bargains relative to their underlying value. In our opinion, the key is to appreciate that while “Growth” is an important input to estimating intrinsic value, “Value” is not. Value is simply the output which investors need to conservatively estimate and compare to the stock price to see if they are getting a good deal.
Felix Narhi, CFA