Equity Investing: The Constant Tension Between Value And Growth Styles

Includes: DIA, QQQ, SPY
by: Brian Gilmartin, CFA

The famed martial artist, Bruce Lee, the great fighter who put martial arts on the map in the late 1960s and early 1970s in the US, once had a remarkably insightful comment about the various fighting styles. When asked which style was the best, his brilliant response, which isn't limited to the confines of the fighting world, was, "The best style, is no style".

Although every fund family, portfolio manager, equity strategist and commentator, employs their own way of investing, I've broken down the "equity style" world into 5 primary groups;

1.) Deep value: Back in the late 1990s when I was just starting out and trying to build a book and a track record, the "deep value" stocks were gold, precious metals, basic materials, steel stocks, and pretty much anything that was not technology, financial services, pharma, or large-cap retail. Ironically, today, those sectors that were growth in the late 1990s are "value" or "deep value" today.

"Deep value" to me involves companies trading at less than tangible book value with sustainable cash-flows, that have been long-term underperformers and actually might have lost considerable analyst following as their performance has lagged over a long-time frame. Our best example of "deep value" today would be Alcoa (NYSE:AA), trading at 75% of its tangible book value [TBV] of $10.95 per share, but still generating free-cash-flow. Two more examples might be Dell (NASDAQ:DELL) and Hewlett-Packard (NYSE:HPQ), both trading at 4(x) - 5(x) earnings and 3(x) cash-flow. While Dell and HPQ might not be trading below tangible book value, the cash-flow valuations are at their lowest levels in a generation. There are still a lot of analysts following these names, so maybe it is still too early to own.

A good example of how analysts fall off a sector or company radar is the railroad stocks in the early 2000s. You couldn't give someone a railroad stock in the late 1990s. The charts were basing for years, and there was a complete lack of interest in the sector, by the time the names really began to pick up steam. When Mr. Buffett jumped into the fray, buying Burlington Northern (BNI), there weren't too many strict railroad analysts out there.

Probably the single identifying hallmark of "deep value"investing is that investors can sit on these stocks for years, as there was probably a secular competitive change to the business, with little to no change in earnings and revenue growth rates.

Bank stocks in early 2009, particularly smaller and mid-cap banks that were off the radar, probably qualified as deep-value stocks, given the decimation of financials and the collapse of housing. (Long AA, small position in Dell and HPQ)

2.) Value investing: The traditional definition of value investing is buying companies whose price-to-book value is less than 1(x). While that is a hard-and-fast quantitative statistic, many mutual fund families and investors define "value investing" very differently. Value stocks or sectors usually have valuation metrics, including revenue and growth rates lower than the S&P 500 as well as reasonably-attractive book values.

The semiconductors stocks (today) likely qualify as "value" stocks, although their valuations are greater than 1(x) book value. Intel, (NASDAQ:INTC), Sandisk (SNDK), Applied Materials (NASDAQ:AMAT) and such are trading at 10% - 15% free-cash-flow yields, and single digit earnings multiples. "Value" investing is the preferred method of investing for risk-averse investors, since it is thought that buying at such low valuations limits an investor's risk of loss.

I would also call Ford Motor (NYSE:F) a value stock today, trading at 5(x) automotive cash-flow and 3(x) consolidated (auto and financial) cash-flow. Value investing today implies very attractive valuations (i.e., low price-earnings, low price-to-book, and low cash-flow) metrics, but that isn't always the case, as you will read below. (Long INTC, SNDK, F)

3.) GARP, or "growth-at-a-reasonable price": This equity style of investing is probably the widest band in the equity world, since it encompasses both "value" and "growth" styles. GARP investing usually implies that the stock's earnings multiple and earnings growth rate are probably close to or above the S&P 500's multiple and earnings growth rate, but the stock is temporarily out of favor.

Good examples are retail stocks that have been hit hard lately. Names like Tiffany(NYSE:TIF), Coach (NYSE:COH) and others have gotten hit hard in 2012 (i.e. negative total returns for the year), while the S&P 500 is up nicely, and yet the valuations have contracted (or are contracting) so that growth investors are looking to buy at "value" prices. Turnaround situations like a JC Penney (NYSE:JCP) might fit into a GARP portfolio, or even a more patient growth portfolio.

4.) "Growth" stocks or growth investing was traditionally defined as buying or owning companies that have earnings and revenue growth rates that are growing faster than the S&P 500, and for most investors, that typically implies an earnings multiple that is higher than the S&P 500.

Traditional blow-hards in the investment management business often sniff with contempt at tried-and-true "growth" investors, as if growth managers are some crack-sniffing, gentleman's-club activists that live on the edge and cliff-dive to start their day. In fact, most of the great companies through the 20th century, like Ford Motor , GM (NYSE:GM), were growth companies for long periods of time.

Unfortunately, I learned my lesson the hard way in 2001 and 2002, and watched growth stocks come apart with a severity that still makes me shiver today. If you are going to own a growth stock, be sure and have a drop-dead point at which you are a seller, regardless of circumstances. Technical analysis helped me be a better growth stock investor, since it forces me to sell at a particular level.

We are long a few growth stocks today in client accounts, including Visa (NYSE:V), Amazon (NASDAQ:AMZN) and Starbucks (NASDAQ:SBUX). We just limit the position size; in the case of Amazon, given its valuation, we have just a 1% position in clients accounts, but are fully prepared to add at lower prices. (Long V, AMZN, SBUX)

5.) Momentum investing: not for the faint of heart, momentum investing requires an overall market where P/E ratio on the S&P 500 is expanding, and these hyper-growth companies don't last very long. I would not suggest momentum investing for the typical retail investor: it is too risky - even a modest tempering of earnings guidance on a quarterly conference call can result in a stock down 25% - 30% in a month. Look at Chipotle (NYSE:CMG), when corn prices started to rise. When it comes to mo-mo style investing, the retail investor is often what I call LILO (last-in, and last out).

One thing to be clear: there are many good investors that are "either/or" style investors, and even though the title of their fund or firm says one thing, what they buy tells you volumes.

Bill Miller, the portfolio manager of the famed Legg Mason Value Trust, outperformed the S&P 500 for most of the 1980s and 1990s. His fund was titled or labeled as "Value" but he really owned growth stocks that met the definition of stocks trading at deep discount to "intrinsic value". No question, Bill Miller was a tremendous investor, and very astute. I still think today, that "growth" investing requires a general market (read S&P 500) where the P/E ratio is gradually increasing over time. We've been in a market the last 12 - 13 years of "P/E contraction" and thus, growth stocks are probably more attractively valued today than at any time in the last 20 - 25 years.

Another good example: The Oakmark Funds here in Chicago where David Herro and Bill Nygren ply their trade, is a traditional "value" investing shop, more along the lines of Warren Buffett. My guess is, Oakmark didn't own anything Bill Miller did in 1999, and for good reason.

However, Bill Nygren made a very interesting point in an interview several weeks ago. He said that investors today are paying far less for "growth" stocks today than they did in the late 1990s, from which we can infer that valuations on traditional growth stocks (maybe like Visa, or SBUX) are lower on "growth" today, than where growth traditionally trades. (Although he didn't attribute the reason specifically to P/E contraction, for 12 - 13 years, we have been in a market that is the complete opposite of the 1980s and 1990s.)

My guess is, if you look at the Oakmark portfolio today, you'd see a few names that might lend themselves to traditional growth investing, that might have been anathema to Oakmark 12 years ago.

To summarize anything about investing is a difficult task at best, but when you break down the various styles, and then add the 10 sectors of the S&P 500, and then add the 9 asset classes within equity investing (large-cap (l/c) value, l/c blend, and l/C growth, then do the same for mid-cap and small-cap) you wind up with a pea soup that is more pea quicksand.

What is even more interesting is that, in the last 12 - 13 years, I've watched "value" stocks like gold and steel stocks, become "growth," and growth stocks, like Intel and Dell, become almost "deep-value" names, hated by investors, shunned by analysts and under-owned by The Street.

At any given time, sectors can be moving from one spectrum to another, and when value managers are selling a stock, growth managers might be buying that same stock. Let's say you owned a steel stock in 1999 or a copper stock like Freeport McMoran (NYSE:FCX), which I'll bet was trading at 5(x) earnings and 5(x) cash-flow in 1999. Then we get the tsunami that was the tech bubble breaking, and China starts to grow at annual GDP rates of 12% - 15%, thus FCX, trading at $3 per share in October, 2000, starts to get an earnings catalyst from China and Europe.

As FCX trades up to $10 per share, maybe the deep value manager who was buying FCX between under $10 for most of the late 1990s says, "I'm out," since the valuation starts to get extreme for that style of investing, meanwhile the value, GARP and even growth manager, starts to see earnings and revenue estimates start to tick higher, and they start nibbling at the stock. The value manager might own FCX from $10 to $25, as would the GARP manager, at which point, both the GARP and growth managers make a calculated bet that China's GDP growth will continue for a few more years, at which point the growth and GARP manager double their position, while the rigorous value investor, says "2(x) book value is too salty for me, regardless of earnings growth" and he sells to the growth manager.

In fact, I don't know if this happened with FCX or the steel sector, but the progression does happen.

Since we manage money for high net worth investors, and we like to pick stocks for clients' accounts, while leaving the bond or fixed income side to mutual funds, ETFs and closed-end funds, we like to own stocks in each style and like to overweight sectors to try and mitigate equity market risk.

One final point: valuation can be deceiving. I can't tell you how many homebuilder investors we listened to in the early to mid 2000s talking about the "low p/e ratio's of 5(x) - 6(x)" on homebuilder stocks as a reason to be overweight the sector, only to watch that sector get crushed. (Fortunately, after living through the tech crash, we avoided the housing and homebuilder bubble almost completely, with the exception of the banks.)

In the case of cyclical stocks, you want to buy when the P/E ratio's look quite elevated and pricey (meaning earnings are cyclically depressed), and you want to sell when the P/E ratios are at their tightest and valuations actually look attractive.

After 20 years of being solo and managing money for clients, the only hard and fast rule I have is that there is no hard and fast rule to investing.

If you are looking for one sector with attractive valuations, good dividends, that fits "value" parameters, but could see changes that might accelerate earnings and revenue growth, it is the large-cap pharmaceutical stocks. Left for dead in 2010, and in a bear market since the late 1990s, the pharma stocks, and more importantly pharma managements, are starting to reduce expenses, to improve margins, to improve earnings growth. [long Pfizer (NYSE:PFE), Merck (NYSE:MRK), Johnson & Johnson (NYSE:JNJ), Amgen (NASDAQ:AMGN)]

There will always exist a tension between what is undervalued and waiting for a catalyst and what is seemingly overvalued and what will be the catalyst to drive prices lower. The 10 sectors of the S&P 500 are always in some sort of flux between the various styles, depending on the macro, and the market itself (what is happening with P/E ratio's).

For 2012, there is not much of a performance disparity when looking across large-cap to small-cap and from value to growth styles. In fact the performance distributions seem pretty normal.

Be careful out there and don't forget to sell.

Disclosure: I am long AA, INTC, SNDK, F, PFE, MRK, AMGN, JNJ, V, SBUX, AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.