Value Versus Growth — II

One of my readers posted the following comment, and I felt it was worth following up:

I continue to struggle with the Growth vs Value designation (never mind where to invest). According to Buffet’s letter, they are joined at the hip (growth being an important part of value), whereas you indicate that there is a real difference between Value and Growth.

Does “Value” as a category of stock arise from the way it is priced or is it solely dependent upon the condition of the company? Is the “Growth” designation simply a function of the rate of change of earnings (or some other financial measure) or is it related to the eagerness of buyers?

If I am reading you right, you are saying that value applies to a stock (not a company), and that value investing does not require (earnings) growth to be successful, whereas growth investing is paying a premium, and thus requires sustained, substantial earnings growth to be successful (because you are paying so much for the shares).

It always seems like “value” stocks are the one’s investors don’t want (if people are paying a premium, it is not a “value” stock). If few people are interested in buying the stock right now, when the underlying business is fine (or at least unimpaired), why would they be willing to pay more in the future? It seems like that would only happen if earnings grow (so it is a “growth” company?) or if people decide they would like to pay more for the same earnings. Are future buyers going to pay more because they see that earnings simply aren’t falling? Or is most of the return going to come through dividends and/or share buybacks?

This seems like something very fundamental, but the amount of confusing comments (around the internet) about these terms seems second only to confusion related to the term “risk”.

Imagine for a moment that you had the influence over a company such that you forced them to liquidate it.  Going out of business.  Selling everything.  With a company characterized as a value stock, you would make money off of such a venture.  With a growth stock, you would certainly lose.  Growth stocks are going concerns, and need to continue in operations in order to increase their value.  Even a value stock does not generally want to liquidate, but they don’t need to grow much to maintain the value of the enterprise.

With value stocks, most surprises are positive, because expectations are low.  With growth stocks, most surprises are negative, because expectations are high.

Buffett is right.  Value and Growth are joined at the hip.  What he means by that is that a company with predictable growth deserves a higher valuation, with which I totally agree.  The stereotyping of growth and value stocks stems from human prejudices where people segment the market into two or three areas:

  • Buy the fastest growing companies, at any price.
  • Buy growth at a reasonable price.
  • Buy companies that will do okay even if they don’t grow.

Value is a question of price only.  There is no such thing as a bad asset, only a bad price.  I like buying growth companies, and I do so when they are offered to me at bargain prices.  I will pay up a little for a growth company, in the same way that I would pay up for bonds of higher credit quality, while losing a little yield, but not a lot of yield.

This is not to say that all value investing will succeed.  I have my share of failures.  The idea is to tip the odds into your favor by buying things that are out of favor relative to their current assets, or likely future earnings (or free cash flow, for the advanced).

Risk is a question of permanently losing capital.  That is the downside on which all investors should focus.  Though I do lose money on some stocks that I buy, my goal is to lose money on none of the stocks.  If I cover the downside, the upside will take care of the rest, because the goal of a value investor is to not lose money over the long haul.