Value Versus Growth

Value Investing and Growth Investing are variants of the greater school of Fundamental Investing.  Quoting Buffett from his 1992 Shareholders Letter:

Our equity-investing strategy remains little changed from what it was fifteen years ago, when we said in the 1977 annual report:  “We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety.  We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.”  We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute “an attractive price” for “a very attractive price.”

But how, you will ask, does one decide what’s “attractive”?  In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition:  “value” and “growth.”  Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago).  In our opinion, the two approaches are joined at the hip:  Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, 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).

Whether appropriate or not, the term “value investing” is widely used.  Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield.  Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.  Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.

Similarly, business growth, per se, tells us little about value.  It’s true that growth often has a positive impact on value, sometimes one of spectacular proportions.  But such an effect is far from certain.  For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth.  For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value.  In the case of a low-return business requiring incremental funds, growth hurts the investor.

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here:  The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.  Note that the formula is the same for stocks as for bonds.  Even so, there is an important, and difficult to deal with, difference between the two:  A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future “coupons.”  Furthermore, the quality of management affects the bond coupon only rarely – chiefly when management is so inept or dishonest that payment of interest is suspended.  In contrast, the ability of management can dramatically affect the equity “coupons.”

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.  Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.  The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.  Unfortunately, the first type of business is very hard to find:  Most high-return businesses need relatively little capital.  Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

Though the mathematical calculations required to evaluate equities are not difficult, an analyst – even one who is experienced and intelligent – can easily go wrong in estimating future “coupons.”  At Berkshire, we attempt to deal with this problem in two ways.  First, we try to stick to businesses we believe we understand.  That means they must be relatively simple and stable in character.  If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows.  Incidentally, that shortcoming doesn’t bother us.  What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.  An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price.  If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying.  We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

In theory, growth factors into value calculations.  In practice, growth estimates disappoint.  Fast growing companies have negative surprises, whereas slow growing companies have positive surprises.

Growth stocks have stories.  Value stocks are in the shadows.

Growth stocks are the uncertain future.  Value stocks are the discounted past.

Growth investors expect high ROEs to continue.  Value investors often buy companies with low ROEs, and don’t expect much.  The difference is significant.

What Buffett describes as “Value Investing” is what he learned from Ben Graham.  Margin of safety, buy them cheap.

But margin of safety implies that if things go wrong, losses will be small.  This precludes growth investing, because if growth fails losses will be large.  Thus, value investors focus on situations where earnings are high relative to price, with growth likely low, and net worth high relative to market capitalization.

Yes, I understand about moats, and what they imply for growth investing, but given changes in technology, moats aren’t that common over a decade.

As such, I say to you that there is a real difference between value and growth investing.  Value looks for a margin of safety and buys cheap, knowing that growth is uncertain.  Growth assumes that earnings growth will continue, even if the market is getting saturated.

I am happy to be a Graham-and-Dodd value investor.  I don’t need growth to make money.