Growth Value
stock volatility high low
character aggressive defensive
upside high limited
downside can be high low
firms have very bright future cheap assets
outperforms bull market bear market
benefit from market greed market fear
(sell high) (buy low)
uncertainty extent of rise timing of rise
portfolio size 50 issues 100
All this is leading up to talking about why buying is the crucial step for value investors, selling the most important for their growth counterparts.
The growth stock investor’s answer: Joe’s, of course. Why? I pay $18 for the stock now. At the end of five years, earnings per share will likely be $2.70. Assuming the stock keeps the same p/e multiple, its price will be $48 and I will have almost tripled my money.
Look at Bill’s in contrast. I pay $10 for the stock. At the end of five years, eps will be up 61% and I will have collected $2.50 in dividends (which I may have to pay tax on, but let’s not count that here). Assuming the stock keeps the same multiple, it will be trading at $16.10. Add in the dividends and the total is $18.60. That’s a return of 86%, or about half what I would get from holding Joe’s.
One more thing. Maybe in five years, people will start to worry about whether Joe’s can continue to expand at its current rate. As a result, the p/e multiple could begin to contract. Maybe that will happen, maybe not. But even if it does, the multiple will have to drop from 18 to 12! before I would be better off with Bill’s.
The value stock investor’s answer: It’s obviously Bill’s. Joe’s has a much more aggressive growth strategy. Maybe it will work, maybe not. I don’t see why I have to decide. A lot of the potential reward for success is already built into Joe’s current stock price. And if Joe’s strategy is unsuccessful, the stock has a very long way to fall.
If Joe’s strategy doesn’t work, then I’m much better off with Bill’s. On the other hand, suppose it really is the way to go. In that case, either Bill’s management will see the light and adopt a more aggressive stance itself, or the board or activist shareholders or a potential predator (Joe’s?) will force a change. And the stock will skyrocket. While it may take a little more time, I’ll enjoy all the rewards of backing the winning strategy without taking on the higher risk of holding Joe’s.
It’s a question of temperament. A conversation between the growth and value sides could have several more rounds before it degenerated into name-calling, but you have the basic idea already.
Maybe the most salient points to be made about each answer are:
–not that many companies grow so rapidly as Joe’s without any hiccups;
–wresting control from an entrenched management is not that easy (look at the sorry history of Western-style value investing in Japan–or most places in Continental Europe, for that matter–for confirmation). It may not be possible, and could be a long and arduous process in any event.
Yes, I was supposed to be writing about trading. But I figured it might be useful for readers to figure out whether they tend to like growth stocks or value ones before going further. Here’s a test I heard about while I was at a value-oriented shop in the early 1990s (it’s a rerun of a one of the first posts I wrote in 2009. Try not to look back to see the answers, which will appear again tomorrow.):
The Rules
I’ll describe two companies. Both are retailers, operating in the US and selling identical merchandise. They are located far enough away from one another that there is no chance of them competing in the same markets for at least ten years.
Both have first year sales of $1,000,000.
Both have an EBIT (earnings before interest and tax) margin of 15% and pay tax at a 33.3% rate.
Therefore, both have first-year earnings of $100,000.
Each firm is publicly traded and has 100,000 shares outstanding. Earnings in year 1 are $1/share for both companies.
Money reinvested in the business is currently generating $2 in sales for every $1 invested. There’s no lag between the decision to invest and the generation of new sales.
Both can borrow up to 20% of earnings from a bank at a variable rate that is now 7%.
Earnings and cash flow are the same (just to keep it simple).
Company 1: Bill’s Stuff
Bill’s management wants to take a conservative approach to a new business. It decides that it will:
reinvest half of its cash flow back into the business,
pay a dividend of $.50 a share ($50,000/year),
keep any remaining cash in reserve in a money market fund.
So, in year 2 Bill’s generates $1,100,000 in sales, earns $165,000 in ebit and $110,000 ($1.10/share) in net income. It reinvests $55,000 in the business, pays out $50,000 in dividends and keeps $5,000 in reserve.
Let’s assume the company can continue to operate in this manner for as far as we can see. Then, the company’s investment characteristics are:
10% earnings growth rate
$.50 dividend payment
no debt; small but growing amount of cash on the balance sheet
Let’s assume Wall Street is now willing to pay 10x current earnings for the company’s stock.
Company 2: Joe’s Things
Joe’s management believes that expansion opportunities are extraordinarily good right now. It decides that it will:
reinvest all the company’s cash flow back into the business,
borrow the full 20% of earnings that the banks will provide and reinvest that in the business as well.
In year 2 Joe’s generates sales of $1,240,000 and ebit of $185,000. After interest expense of $1,400 and tax, net income is $122,400 ($1.22/share)..
For year 3, Joe’s can borrow another $4,500 and does so. Therefore, it reinvests $126,900 in the business. It generates about $1,500,000 in sales and ebit of $225,000. After interest and tax, net income is about $149,000 ($1.49/share).
Assuming that Joe’s can continue to expand in this manner indefinitely, the company’s investment characteristics are:
22% earnings growth rate,
modest and slowly-rising bank debt,
no current dividend.
Let’s assume Wall Street is willing to pay 18x current earnings for the stock
The question: Which one would you buy, Bill’s or Joe’s?
Answer tomorrow.
Market Basket is a privately held New England discount grocery chain controlled by two third-generation branches of the founding family. One branch, owning 50.5% of MB, is led by Arthur S. and has no role–other than being on the board of directors–in the day-to-day running of the firm. The other is led by the largest single shareholder, Arthur T.
MB recently deposed Arthur T. as CEO and replaced him with two non-family members. Warehouse and delivery workers struck when they heard the news (with the encouragement of Arthur T., some have suggested), preventing the 71 stores from restocking and effectively hamstringing the firm. Recently, the Arthur S. branch has agreed to sell its shares of MB to Arthur T. for $1.5 billion.
Throughout this highly public dispute, Arthur T. has been portrayed as a benevolent retail genius, creating an immensely successful business with fanatically devoted employees and extremely loyal customers. Arthur S., on the other hand, has been seen as a money-grubbing child of privilege who wants to fund his yacht and string of polo ponies by pillaging the workers’ retirement plans.
A lot of this may be true, for all I know. And the issues rocking MB are all pretty routine third-generation family owned company stuff (see my earlier post on MB). But in the feel-good story line being taken by the media, one fact is being overlooked. From what little has been in the press about MB’s profits, it doesn’t appear to be a particularly well-run company. Arthur S. is probably right that Arthur T. isn’t a good manager.
the case for Arthur S.
Let’s say I’m a member of the Arthur S family and I hold 5% of MB’s outstanding stock. I receive a yearly dividend of $5 million. My genetic good fortune is significantly better even than winning the Megamillions jackpot. So in one sense I should have no complaints.
On the other hand, my share of the assets of MB is worth about $175 million. Therefore, my annual return on that asset value is 2.9%. That’s about half the return on assets that Kroger achieves. It’s also just over a third of what Wal-Mart generates, but I’m confident MB doesn’t aspire to be WMT.
I presumably also know that good supermarket locations are extremely hard to find in New England and that those MB has established over prior generations are immensely valuable. It’s conceivable that if MB were to conceptually divide itself into two parts, a property owning one and a supermarket operating one, and have the property arm charge market rents to the stores, MB would see that the supermarket operations lose money and are only kept afloat by subsidies from the property arm. (This situation is more common than you’d think. It was, for example, the rationale behind the hedge fund attack on J C Penney. That fact that inept activists botched the retail turnaround doesn’t mean the underlying strategy was incorrect.)
Even back-of-the-envelope numbers suggest something is very wrong with the way MB is being run. Personally, my guess is that the inefficiency has little to do with employee compensation or with merchandise pricing, although the former has apparently been the focus of the AS’s discontent. I’d bet it’s in sourcing and in how shelf space is allocated.
At the same time, Arthur T is presumably blocking my every attempt at finding stuff out and is rebuffing board suggestions that he bring in help to analyze why his returns are so low. If MB were a publicly traded company, I could sell my shares and reinvest in a higher-return business. I’m probably not able to do this with MB. Even if I were, the public intra-family feuding would suggest the stock wouldn’t fetch a high price.
I have two choices, then. I can accept the status quo, or I can try to create a consensus for the family to sell the firm. That latter is what Arthur S. chose to do.
The July/August 2104 issue of Foreign Affairs contains an interesting conceptual economics article titled “New World Order.” It’s written by three professors–Erik Brynjolfsson (MIT) , Andrew McAfee (MIT) and Michael Spence (NYU)–and outlines what the authors believe are the major long-term trends influencing global employment and economic growth. I’m not sure I agree 100%, but I think it’s a reasonable roadmap to start with.
Here’s what the article says:
the past
Globalization has allowed companies to exploit wide wage differentials between countries by moving production from high-cost labor markets close to consumers to low labor cost areas in the developing world. Former manufacturing workers in high-cost areas enter the service sector to seek employment, depressing wages there.
This period is now ending, as relative wage differentials have narrowed.
now
Relative labor costs are at the point where manufacturing plant location is determined by other factors. These include: transportation cost, turnaround time for new orders and required finished goods inventory. This implies that manufacturing can be located closer to the end uses it serves. However, globally higher labor costs also imply that new factories will be much more highly mechanized than before. Robots replace humans.
As a result, wage growth will remain unusually subdued.
the future
Although returns to capital have avoided the erosion that has befallen labor over the past generation, this situation won’t last. Long-lived physical capital is being replaced by software (note: the majority of investment spending done by US companies is already on software).
Software doesn’t have either the total cost or the permanence of capital invested in physical things. Software can be moved, it can be duplicated at virtually zero extra expense. To the extent that software replaces physical capital as a competitive differentiator, it makes the latter obsolete. It, in turn, can be made obsolete by the innovative activity of a small number of clever coders.
Therefore, the authors conclude, returns on invested capital (especially physical capital) are already beginning to enter secular decline.
Where will future high returns be found?
…in the innovative activity of talented, well-educated entrepreneurs.
education
This brings us to a major problem the US faces. It’s the relative slippage of the domestic education system vs. the rest of the world, and an increased emphasis on rote learning (No Child Left Behind?).
The trio dodge this politically charged issue–they do observe that there’s a direction relationship between the quality of a community’s schools and the affluence of its citizens–by asserting that online learning will come to the rescue. A child stuck in a weak school system will, they think, be able to in a sense “home-school” himself to acquire the skills he needs to succeed in the future they envision.
my take
What I find most interesting is the presumed speed at which the authors seem to think transition will occur.
–Is it possible that we’ve reached the point where there’s no available low-cost labor left in the world? If so, this is a dood news/bad news story for low-skill workers. On the one hand, downward wage pressure will stop. On the other, robotization is going to take place at warp speed, making it harder to find a job.
Relocation of factories will also have implications for transportation companies, warehousing and even the amount of raw materials tied up in company inventories.
–Does software begin to undermine hardware so quickly? Certainly this the case with online retailing and strip malls. But how much wider is this model applicable?
–If the key to future growth is young entrepreneurs, then the sooner we as investors reject the Baby Boom and embrace Millennials the better. This, I think, is the safest way to benefit in the stock market if the New World Order thesis proves correct.