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.

Why do we do time-weighted returns for analysis of portfolios?? Because we are lazy, and they are simple to calculate.? We don’t want to be bothered with the effects of cash flows.

Besides, mutual fund managers don’t make decisions to move money in and out of their funds.? They should not be held accountable for the actions of their shareholders.

Really?? I think that is only half correct.? The good fund manager takes account of his implicit liability structure.? When will people leave, when will they come?? For almost all funds, investors are trend followers.? And the the greater the degree of volatility, the worse the investors are at following the trend.? Thus a manager of a volatile fund should run with more of a cash buffer, particularly when markets are moving down hard, because he will have more of his clients cashing out.? The manager of a volatile fund should also avoid taking concentrated positions, because when he is doing well, his own buying may drive the stocks he owns up, only to see them fall harder when he is forced to liquidate positions when the market is doing poorly, and shareholders are leaving.? Wise managers concentrate near bottoms, and diversify near tops.

Now for my poster child, the Legg Mason Value Trust.? Bill Miller is a very intelligent guy, and has a very talented staff.? My main criticism of his management is that it neglects the core concept of value investing, which is “margin of safety.”? The core concept is not cheapness, or as Bill Miller was fond of saying “lowest average cost wins.”

Legg Mason Value Trust enthused investors as they racked up significant returns in the late 90s, and the adulation persisted through 2006.? As Legg Mason Value Trust grew larger it concentrated its positions.? It also did not care much about margin of safety in financial companies.? It bought cheap, and suffered as earnings quality proved to be poor.

Eventually, holding a large portfolio of concentrated, lower-quality companies as the crisis hit, the performance fell apart, and many shareholders of the fund liquidated, exacerbating the losses of the fund, and their selling pushed the prices of their stocks down, leading to more shareholder selling.? I’m not sure the situation has stabilized, but it is probably close to doing being there.

But now to the point: what did Bill Miller earn for shareholders?? The earliest date that I could get data for was 3/31/1993, probably due to the creation of EDGAR in the mid-90s.

On a dollar-weighted basis, he earned 2.71%/year for investors through 10/31/2010.? But for those stout-hearted souls that bought and held, they earned 6%+ more, 8.78%.? But those that did that had to be patient, even Stoic, people who had no need for liquidity, and no propensity for panic.? (There is always enough time to panic. 😉 )

Legg Mason Value Trust was a volatile fund, and as such, it is no surprise that the difference between time-weighted and dollar-weighted returns are so large.? But what does this imply about Bill Miller? He beat the S&P 15 years in a row.? But as posts like this point out, did he go from first to worst?

His neglect of the core idea in value investing, margin of safety, allowed him to do well as the lending bubble expanded, and low quality companies prospered.? But when the tide went out, he was found to be swimming naked.? Far from following Buffett’s principles, or Graham’s, he was just a growth investor masquerading as value investor because “he bought them cheap.”? And they got a lot cheaper, and he had to sell them cheaper still.

So what are the lessons here?

• Focus on margin of safety in investing.? Analyze balance sheets.
• Avoid investing in popular funds, even excellent managers make mistakes when lots of money is coming in.
• Stick to your knitting.? Don’t engage in all manner of fancy logic once you achieve success.? Stay humble.
• Remember that your timing in investing makes a difference.? Don’t be quick to add to a winning fund.? Better to find a fund with good ideas that is temporarily underperforming.
• Buy-and-hold often beats the average investor over the long haul.? Some traders might do better, but have you developed that skill?
• Avoid managers that say a lot of clever things, but can’t deliver on returns.

So be wise, and realize, you are still responsible for your investment success or failure, even if you hand it off to others.

I received a question from a friend of mine and want to give an answer:

Background: I teach high school physics.? In my AP class, I have some cross-registration with the Micro-econ & Personal Finance classes.? In those classes, they play the “Stock Market Game” in which they’re given $25k and compete for the semester for the highest total.? Inevitably, discussion of economics, stocks, and that game finds its way into my class where I am incapable of _not_ getting involved.

Problem 1: The game only lasts for a semester (4 months).? Result: very short term thinking

Problem 2: The teacher pushes stock-chart reading, “200 day average vs 50 day average”, looking at price movements, etc.? There is little (if any) balance sheet reading, company growth investigation, or stock price evaluation going on.

Relevance for here: The kids immediately turn to penny stocks thinking to make a quick buck- “If I buy 50,000 shares of this company at $0.25, I can sell it for a huge profit when it goes up to $0.50.

Question: Do you have any recommendations for short quips / talking points to reveal their folly to them??

(I had a kid last year almost not graduate when he became so enamored with playing the stock market that he thought he could “crack the code” and make a fortune off penny stocks.)

I have only experienced one good investment contest in my life.? It was in 1983-1984, when Value Line sponsored a contest offering significant prizes.? They did something unique: they divided the market into 10 groups sorted on volatility, and told investors that they had to pick one stock out of each of the ten groups.

Brilliant. this eliminated the ability of people to just pick risky stocks, and bet on getting lucky turning the whole thing into chance.

A portfolio of ten equally-weighted stocks demonstrates more ability than a single pick.? For any single stock, or concentrated portfolio that does well, the answer should be that they got lucky, as humans see it.

As it was, in the Value Line Contest, I finished just short of getting a prize.? My returns were less than a percent behind the lowest winner.

Now as to what you should do, dear friend, in the short run, momentum matters more than valuation, most of the time.? The teacher may be giving them the right advice for the contest.? Personally, I would go to the teacher, rather than the students, and tell him to do a contest more like Value Line did.? If he needs help with the volatility groups, I can provide the data.

But the two main things to point out on penny stocks is this: 1) Most people investing in penny stocks lose a lot of money, because the stocks seem cheap, but they have little in assets or earnings relative to their price.? 2) There are penny stock promoters who tout penny stocks so that others will buy at a higher price, so they can sell to them, and the new buyer can experience the losses.

If the contest is structured properly, it should have a minimum capitalization limit, and a diversification requirement.? Tell the other teachers to consider this.