Value investor with a deep passion for understanding and a desire to improve results over time.
Growth or value? I'd wager that some variation of this question is asked more often on Wall Street than nearly any other, and it has the consequence of dividing the universe of stock investing into two neat compartments (you might argue that it's a little too neat).
The narrative goes something like this: growth stocks have a bigger payoff in the far future, tend to follow momentum trends in the market, and represent much smaller companies with more room to grow. Value stocks, on the other hand, are very slow growers (or even non-growers), trade below their book value or intrinsic value, and often require contrarianism in order to summon up the courage to invest.
Here, I'll offer some reasoning as to why this bifurcation isn't really necessary and might even be harmful to your investing performance, and I'll throw out three thought experiments to help you figure out a better way to think about growth as it pertains to valuation.
Modern Value Investing
It's no secret that I identify as a value investor. This must mean that I read through all of those old Moody's manuals, page by page, looking for discarded cigar butts, right? Well, no.
In fact, modern value investing began to deviate seriously from what Ben Graham suggested in his magnum opus, The Intelligent Investor, as early as the 1980s. Warren Buffett himself provided poetic language in his 1989 letter to shareholders to make the point:
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Clearly, scraping the bottom of the barrel was now out of fashion. Keeping another Buffetism in mind, that the intrinsic value of a business is the sum of all future cash flows, we can see that future carries a lot of weight here. If a wonderful business is growing and reliably reinvesting in its own future, with terrific prospects, that growth needs to be taken into account.
Thought Experiment #1
I do prefer using base, bear, and bull case scenarios any time I'm contemplating a stock's intrinsic value, and I recommend doing this with these thought experiments. Once you have a rough estimate of what a business is going to do in the future, the first question to ask is:
How long will it be until I get my money back?
This simple question goes a long, long way toward establishing a real margin of safety around your initial investment. Think about it: if your initial principle is returned in short order, you could theoretically reinvest it again elsewhere, and the capital you put to risk has now been returned, just as though you held cash the whole time.
Now, cash isn't risk-free by any stretch. Inflation is generally the omnipresent threat, and it does need to be taken into account by discounting what your cash would otherwise be worth. Another way to ask the same question might be:
How long will my cash be tied up, so I can't invest it somewhere else?
After all, this opportunity cost is a huge component of what you might lose during an investment: the ability to invest somewhere else for a certain amount of time.
Thought Experiment #2
The next question follows closely on the heels of the first question. Once you know how quickly your initial investment will be returned to you, the next thing to ask is:
How long until I double my money?
The entire point of investing is to increase the amount of money you have (leaving wealth preservation aside for now; that's an important caveat). A very simple way to think about this is to wonder how long it'll be until your principle has had a little money-baby of identical size.
Asking the prior question about how long it'll be until you get your initial investment back leads you down one path, typically only a few years long. If the company is growing, you'd expect the answer to the second question to take considerably less time. Taking a look at how these two answers compare can give you a good idea of how growth will factor into value over the next decade or so.
Thought Experiment #3
Asking when you'll get your money back is really important, so you can establish a baseline for the current business into the near-term prospects you can probably see and predict fairly reliably. The second question, about how long until you double, causes you to take growth into account to a higher degree. This final question takes your thinking to another level:
How long until my money doubles again?
This may seem like the same question all over again, but let's use an arbitrary example so we can see what this means a little more clearly. You bought a business during year one, and that business took four years to return your initial investment; once you got this initial cash back, you felt like a lot of your risk was gone instantly. Then, you doubled your cash over the next three years—less time than before to produce the same amount of cash since the business is growing. Can the business double again in two years?
This third layer of questioning doesn't only take into account the growth of the business, as the second layer does. It also considers that there could be accelerating growth or growth of growth. Growth rates of companies often fluctuate, and if you find a fast-growing company, you will often see the growth increase over a multi-year span. Those are great companies to invest in when you can buy them at a fair price.
Growth and value are joined at the hip, not opposing forces. Understanding this relationship is important in order to determine how an investment might fare over time; without taking growth into account, you're missing half of the picture.
Buying stocks below their intrinsic value is what makes you a value investor, and you need to consider the future growth of a company in order to determine intrinsic value. Instead of avoiding companies with growing earnings, these are exactly the types of companies to covet, especially when they're on sale.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2022 Andrew Smith