Growth and Value are not opposite segmentations

By Larissa Fernand |  21-08-21 | 
 
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About the Author
Larissa Fernand is Senior Editor at Morningstar.in. Follow her on Twitter @larissafernand

The clichéd value investor is one who holds statistically cheap stocks, and a growth investor holds statistically expensive stocks. It is time to reject these conventional segmentations, and accept that they are not diametrically opposite to each other.

Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance. Growth is simply a component -- usually a plus, sometimes a minus -- in the value equation. Berkshire Hathaway’s shareholder letter in 2000

Nothing like setting the tone with a quote from Warren Buffett. Now, let’s move on to what some seasoned investors have to say about it.

It is a myth to believe that Value and Growth are completely different.

  • Who said this? Sanjoy Bhattacharyya, managing partner at Fortuna Capital, and one of India’s most recognised value investors.
  • Where can I read his views? 5 stock investing myths

All investing is value investing, the differences are just semantic. Value is when you put in Re 1 in the hope that after adjusting for inflation, at a future point in time, that unit is worth much more. The aim is to own a business at a price less than what you think it is worth going into the future.

To say that value investing is all about low PE stocks is farthest from the truth. Quantitative metrics such as PE and PB and dividend yield are statistical measures to test hypothesis; they do not define what is value.

Growth is the largest component of value.

Buy businesses that over time will have an advantage over their competitors. Analyse whether they can sustain and increase that advantage. Buy businesses that will earn a reasonable growing rate of return on the capital they deploy in their business. Most important is the quality of the business, and if your interests are aligned with the people who manage it.

Only when you are sanguine about the prospects of the company, then you look at what you are paying for it - valuations.

The quality and growth dimensions may lack in-your-face tangibility — they are often more difficult to quantify — but are very important sources of value.

Growth is a tricky dimension. On a stand-alone basis it means very little and can often be dangerous. A company that grew earnings at a fast pace in the past but lacked a sustainable competitive advantage (a bedrock of quality) will invite competition that will destroy current and future profitability.

When you combine growth with quality, the mixture is magical and will result in a lot of value. This value lies in future earnings. Another way to say the same thing is: A high-quality company with a high return on capital married to a significant growth runway — the ability to reinvest at a high rate in the future — will create significant value, which will not be observable in last year’s or even next year’s earning power but years from now.

Think about some of Buffett’s best investments: American Express and Geico. Both had significant competitive advantages. In the case of Geico, it sold directly to consumers and thus was a low-cost producer in a commodity industry. American Express simply had an unassailable brand. Both had a huge growth runway ahead when Buffett purchased them.

Are multiples of earnings or book value all that is involved in valuation? 

It was a question he was often asked since high multiple (Google) and low multiple (Citigroup) names co-inhabited in his portfolio. He countered this question with another: Are multiples of earnings or book value all that is involved in valuation?

According to him, too much time is spent thinking about businesses via simple-minded, short-term factors like current earnings acceleration or deceleration, or the day’s P/E or P/B multiple. As a result, investors react to this information and sell stocks which seem expensive. The biggest opportunity is really thinking out longer term.

Value investors choose securities based on their assessment of intrinsic value, which is the present value of the future free cash flows of the business. But valuation is inherently uncertain because all the information (100%) you have about a company represents the past, and all of the value (100%) depends on the future.

Since trying to figure out the present value of the future free cash flows of a business involves a high degree of estimation error and is highly sensitive to inputs, he employed various valuation methodologies known to assess business value and did not restrict himself to just discounted cash flow analysis.

Miller was of the opinion that one can simultaneously buy low PE and high PE stocks if both are mispriced. In the mid-1990s, cyclical stocks such as Steel, Cement, Paper Aluminum were being bought by classic low PE and low PB parameters. But tech stocks were also selling at very cheap prices; Dell Computers at 5x earnings and Cisco at 15x earnings.

His judgement to buy the latter, which suggested ratiocination rather than intuition, proved extremely beneficial (he offloaded them in the tech mania of 1998 and 1999). Why own a cyclical company that struggles to earn its cost of capital when you could get a real growth company that earned high returns on capital for about the same price, he reasoned. Granted, tech was not predictable in the way Coke, for example, was. But Miller had learned about path dependence and lock in, which meant that while technology changes rapidly, technology market shares often don’t, so they were much more predictable than they looked.

He evolved his strategy to not just buy companies that were cheap statistically. His modus operandi was to look for stocks where the market is missing a significant source of value and hunt for companies that are able to generate sustainably strong returns on invested capital. In other words, value stocks of companies with high profitability.

And, of course, stocks move up and down the growth-value spectrum. Is Apple a growth or value stock? is a stark example. 

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