Growth is Cool, Value is for Nerds

by: Todd Kenyon, CFA

It's true. To be a value investor, you must be a Wall Street outcast. You are required to be a member of the chess team and the audio-visual club. You spend prom night at the mall's video arcade. Amazingly though, value strategies have beaten growth strategies again and again throughout history (come to think of it, most of those high school nerds probably way outperformed the "cool crowd" later in life). Think of just about any of the most famous investors of all time. Yup, they're nerds. RICH nerds.

Value investing may be simple, but it's not easy. Growth or momentum investing is far easier psychologically, since you typically follow the crowd and hang out with the popular stocks. By definition, to get bargains you must buy stocks that the market ignores, dislikes, misunderstands, or all of the above. In essence, you must go in and buy companies while the market, incorporating thousands or even millions of intelligent and experienced individuals, screams at you that you are an idiot. At the very least, you're not one of the "in-crowd". Worse yet, Mr. Market may continue to berate you for months on end. That nerd thing again.

How does one define growth versus value anyway, other than by where their respective practitioners sit in the Wall Street cafeteria? Just ask Wall Street - it loves to slice and dice things into neat little categories. Stocks are commonly divided into sectors, industries, market cap, and growth or value categories among others. Mutual funds are crammed into "style boxes", and so on and so on. A lot of this has to do with figuring out ways to get more of investors' money into more different products: "What - you mean you don't have any East Asian micro-cap core growth exposure? Are you nuts? Better put some cash into our fund!"

I have a much simpler system: good investments and bad investments. As a true value nerd and I have tried to explain in prior posts what that means to me. It really refers to the process I use and the way I look at investing. It does not mean that I look for "value stocks" and avoid "growth stocks" - arbitrary classifications that mean nothing to me. I simply look for good companies selling at bargain prices. Since I attempt to estimate an investment candidate's intrinsic value, I think I know when I am getting a bargain. But here is the key regarding growth vs. value. They are mutually dependent - you can't talk about one without considering the other.

Value is heavily influenced by growth. If a company is able to grow its cash flows for a sustained period, it will be much more valuable than the same company with no growth. Any value investor will tell you that the true value of a business is the discounted sum of future cash flows. So to the extent that there is more cash being generated each year, the value is greater.

We can look at a very simple example using a basic valuation equation known as the dividend discount model (nerd alert!). This model simply says that the value of a company is the cash it will generate next year, divided by your required return less the long-term expected growth of the company's cash flows. Let's say a company is expected to generate $100M in free cash, and you believe it can grow this cash stream at a 7% annual rate. You require a 12% return on your investments. The DDM says this company is worth $2B. What if the company has very little growth left? Say the best it can hope to do is grow at 2% annually. The DDM now tells us the company is only worth $1B. Clearly the growth rate makes a huge difference in intrinsic value.

The danger here is assuming that very rapid growth in the past will continue unabated. If you plug 11% growth into the above equation, the model values the company at $10B, or 100x free cash! You may be asking yourself what good is a model that throws out such a huge range of values depending on your assumptions for one variable. This is a very valid question - the DDM or the related discounted cash flow model can be used to justify any valuation (and frequently do in sell-side research reports) depending on growth and return assumptions.

I love to find companies with robust growth prospects, with one caveat. The less I have to pay for that growth, the better. I simply will not base my valuation models on heroic assumptions about growth. I ideally want growth to be a "free call option": if it occurs, it's free upside. The economy's long-term nominal growth is about 6% (GDP + inflation). So be cautious when assuming a company will grow much faster than that.

In a recent letter to shareholders of his Third Avenue Funds, esteemed octogenarian value investor, Marty Whitman, described what Wall Street really means by growth:

"Buy growth, but don't pay for it. In the financial community, growth is a misused word. Most market participants don't mean growth, but rather, mean generally recognized growth. In so far as growth receives general recognition, a market participant has to pay up." - Marty Whitman

Of course Buffett has a thing or two to say about this. For example, the oft-cited, "You pay a high price for a cheery consensus".

So there it is. So-called growth stocks are frequently expensive, because the market has already priced in the growth. In fact, there is often a "popularity premium" thrown on top, making these stocks even more expensive relative to intrinsic value. Unfortunately, mid-teens and higher growth rates are rare and usually fleeting. So-called growth stocks typically have had a good run, and if you hopped on, you might be doing well. The problem is that this momentum-chasing works fine until it doesn't. When it stops working, it's too late to do anything about it, as many market participants found out in the tech bubble. I am not "smart" enough to know when it's about to stop working - if a stock is trading well above intrinsic value, it can only be hope or greed that keeps me invested.

This reminds me of a technology conference I attended in late 1999, sponsored by one of the big brokerage firms. One day during lunch, four of the hottest technology mutual fund managers spoke to a standing-room only crowd. Amazingly, they all as much as admitted that their funds' holdings were grossly overvalued, and that one day it would come to an ugly end. "It'll be like 10 large gentleman trying to abandon a sinking ship through a single porthole all at once", said one of them. They knew that their holdings had no valuation support, yet they felt they had no choice but to keep holding these stocks, as it was their mandate to invest in tech stocks. It had worked fabulously for the past few years. I wonder if they each secretly thought that they would be the one "large gentleman" to make it off the sinking ship safely. None of them are still managing mutual funds as far as I know.

The bottom line, in my book, is that stocks priced with "no visible means of support" eventually fall to earth. By support I am talking about intrinsic value. And when they fall, there is usually no advance warning. Hence I always want to know that a stock's price is supported by its true value. Otherwise, I am speculating or gambling, not investing. If I can't rationally see how the valuation numbers works, I won't touch it.

Buffett again:

"... we think the very term "value investing" is redundant. What is investing if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value -- in the hope that it can soon be sold for a still-higher price -- should be labeled speculation (which is neither illegal, immoral nor -- in our view -- financially fattening).

I should add that growth's affect on value can work both ways. A stock which appears cheap based on say a low PE ratio or low Price-to-book ratio may be just as grossly overpriced as that racy Chinese internet stock, or even more so. If the company has negative growth prospects, it may be worth much less than its apparently cheap market price (the dreaded "value trap"). And let's not forget about those companies that burn cash - they too may be worth very little even if their accounting earnings show some growth.

I believe that the stocks in my portfolio are all undervalued, most of them greatly so. Several of the stocks I've been buying during the recent panic are near or below the levels I paid, and some are only slightly higher. Hence I believe there are some great ideas in there for my subscribers, including some well known names and some more unusual picks. Subscribers can easily see the prices I paid for my holdings and thus determine if they are currently even cheaper than when I purchased them. That said I have no idea if these stocks will approach fair value next week, next year, or even many years from now. There are no guarantees in the stock market, but to me value investing is the best way to improve your odds.

Let's face it, if this value stuff was easy or popular, everyone would do it and hence there would be little chance for excess returns. I will end another lengthy post with a cautionary quote from Jim Grant, editor of Grant's Interest Rate Observer:

To suppose that the value of a common stock is determined purely by a corporation's earnings discounted by the relevant interest rate and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defense of Joseph Stalin, and believed Orson Welles when he told them over the radio that the Martians have landed. Investors are prone to be bullish at the top of the market when prices are high, and bearish at the bottom when prices are low. Like war, speculation is a social activity. It is carried out by groups.