Growth vs. Value: I. Value Investing

Investing is a craft skill, like being a carpenter or a shoemaker, a baseball player or a surgeon.  It’s very experience-intensive.  After they’ve been in the business for a while, professional equity analysts and managers find themselves falling into one of the two main investing styles common in the US:  growth stock investing and value stock investing.

This is mostly a matter of temperament, I think.  The practitioners of each style tend to focus on different industries and on firms at different stages of their life cycle, though, so this specialization may also be a function of background and interests outside the stock market.

I’m a growth stock investor, although I started my career as a value investor and have worked for large parts of my career in value stock-oriented firms.  Here’s my take on what value and growth consist in:

Value Investing

Value investing has been around for a longer time than growth, which may be why this style has the better name (who can criticize an investor looking for value?).  It is by far the dominant style in foreign markets, although not quite in the form it is practiced on Wall Street.

Value investors are the hard-nosed realists of the equity world.  They intend to hit for average and not necessarily for power.  They often say that they are looking for companies that are worth $1 and hope to buy them at 30 cents and sell them at 80 cents.

In analyzing a potential buy, value investors tend to concentrate on the company as it is now.  They look at its assets, tangible and intangible, the earnings and cash flow operations are generating, and their growth rate.  Companies of interest would be:

*a firm whose stock is cheap. It has been left behind by the market for no reason other than that the company is in a poorly-understood or slow-growing industry, in other words, it’s not glamorous enough to rate more market attention.  Typically such stocks are trading at unusually low ratios of price/book, price/cash flow or price/earnings, relative to the market or relative to their own history.  Being well managed is another potential bonus.  The investment idea is that there will sooner or later be “reversion to the mean,” and the company will with the rest of the market.

*a firm that has encountered temporary earnings difficulties.  This can be either of the company’s own making or due to a change for the worse in the overall economic environment.  In either case, to be of interest the market’s ensuing selloff of the stock must have been driven by fear and been overly severe.  Here the idea is that company management will straighten itself out, that the business cycle will turn up, or that the market’s panic will subside.  This will cause a reevaluation of the stock by the market.

*”deeper” value investors may look for companies whose assets are sound, but whose returns are consistently below those of the industry leader.  The idea here is that “there are no bad businesses to be in, only bad companies.”  That is, either the board of directors, activist shareholders or potential predators will force positive operational changes that will lead to much better results–and a much higher stock price.  Some investors in this value sub-category will buy simply on the existence of this situation; some will wait for a catalyst for change to emerge.

*the really “deepest” value investors may buy a basket of companies trading at the lowest price/book or price/cash flow.  The argument is that, for all practical purposes, “you can’t fall off the floor.”  That is, the worst that can happen is already factored into stock prices and that the price gains from turnaround situations will way more than offset any losses from bankruptcies.

General characteristics of the value style:

*the stocks tend to have a defensive character, since because expectations are already low, further bad news may not engender further selling

*managers tend to have a good idea of what they expect to happen, but less about when that will occur

*particularly with cyclical and poorly-managed companies, investors usually have a clear idea of how high the stock can go in a more favorable environment.  The major exercise of judgment by an investor, then, is when to buy.

*managers make frequent use of stock screens, using both historical and expectational data (i.e., consensus earnings projections), since the notions of what it means to be a “cheap” stock are well-defined.

Value Traps

Value investors worry a lot about value traps, or stocks that meet all the objective criteria for undervaluation but which will not revert upward to the mean.  I don’t think there’s any one thing that characterizes a value trap, but common causes would likely be:  the company’s industry is in secular decline or subject to rapid technological change (e.g., radio, local TV), so that the worth of the company’s assets is open to question; or a poor management is resistant to change but deeply entrenched (autos), so that change for the better isn’t possible.

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