If you search past posts of mine, I wrote a lot at one point about what value investing is. I thought I would reference them in new posts that would talk about why I think 2023 is a year when there’s money to be made from applying value techniques to sort through the stock market wreckage left by the post-pandemic selloff.
I wasn’t happy with what I’d done back then, so I’m going to attempt a sharply condensed version of that past work this week. Here goes:
Take two companies, with identical operations in the same industry in the US, but in different regions of the country. The industry itself is in its infancy, so there are no near-term limits to geographical expansion.
Company A is growing both sales and profits at 10% a year. It can finance its expansion through internally-generated cash, so it has no debt and can pay a small dividend. The stock is trading at 10x current earnings, a PE equal to its growth rate.
Company B has decided to expand faster and is willing to borrow a modest amount. It is growing revenues at 15% a year. Operating leverage from the debt allows it to expand profits at 20%. It pays no dividend. Its stock is trading at 18x earnings, a PE modestly below the growth rate.
If you had to pick one to own, based only on this information, which would you choose to hold stock in?
For a growth investor, the obvious answer is B.
For a value investor, the obvious answer is A.
The value thought process is: Company B is either right in its more aggressive expansion plans, or it isn’t. In the second case, B crashes and burns …and A is the superior investment. In the first, either the board of directors or activist investors will force the board of A to adopt the more aggressive strategy of B or the company will be taken over (maybe even by B). So investors will either benefit from a large PE expansion or end up owning B at a little more than half the current market price of B.