Category Archives: growth vs value

why buying is the key decision for value investors

June 25, 2015 By in distressed assets, growth vs value, mean reversion, two flavors of value Tags: , , , , , , Leave a comment

Value investors like to describe themselves as buying companies worth $1 for, say, $.20 and selling them for $.80.  Less ambitious practitioners say buying for $.30 and selling for $.70.   But the idea is the same–buy at a deep discount, sell at a slight discount.

What remains unexpressed, but what’s crucial for value investors, is that the firm in question is not being assessed on any pie-in-the-sky future developments, but on an evaluation of what the company as it stands now is worth.

Three types of situations get value investors particularly excited:

–periods of general stock market undervaluation,

–overall business cycle slumps, or specific industry group declines, when the market fears that an (inevitable) upturn won’t happen and decides to unload the underperforming stocks into the market for whatever they can get, or

–companies that are industry laggards and which would fare far better if run by more competent managers.

In a sense, all of these situations involve temporarily damaged goods.

In each case, value investors also have plenty of data for figuring out what normal or reasonable prices for now-undervalued companies should be.  The data might be projections from past industry or economic cycles about how far earnings might rebound during an upcycle and how far price earnings multiples might change (usually expand).  In the case of badly run firms, the comparison is with healthy companies in the same industry.

In every instance, however, it’s a relatively straightforward thing to set a target price–what the company would be worth in better times.

The more difficult question is at what price to buy.

Investors will certainly demand a premium, say, 20% or 30%, for taking the risk of making a purchase while a business may be doing badly or while the overall market is cringing in fear.

Beyond that, value investors seem to me to fall into two types:

–those who are willing to buy at what they consider a rock-bottom price, regardless of the near-term outlook, and

–those who are waiting to see an initial ray of sunshine, or a “catalyst,” that convinces them that the worst is past.

In the first case, the skill is in judging the bottom.  In the second, it’s finding the turn upward before the market in general does.  But in both cases, it’s the decision to buy that’s the key to success.

 

 

 

 

comparing growth and value styles

June 24, 2015 By in book value, distressed assets, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, two flavors of value Tags: , , 1 Comment

 

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.

growth vs. value test: my answers

June 23, 2015 By in book value, cash flow/share vs. earnings/share, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, return on equity vs. return on capital, two flavors of value Tags: , , 2 Comments

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.

testing for style–growth investing vs. value investing

June 22, 2015 By in book value, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, return on equity vs. return on capital Tags: , , 2 Comments

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.

surviving the next twelve months (ii)

June 10, 2015 By in bond market, Constructing a Portfolio, currency markets, Current Market Thoughts, growth vs value, stock market, Strategy Tags: , , , , , , , Leave a comment

two types of tightening

The Fed raises rates in two different situations:

1  to slow down an overheating economy.  This is not where we are now.  In the overheating situation, the economy is expanding at an above-trend rate.  Inflation is accelerating.  Wages are rising rapidly.  The stock market is frothy.  The long bond is trading at inflation +2% – +3% (meaning a nominal yield of 4% – 5%, in a 2% inflation scenario).

As the Fed ups short-term rates, what  follows is a garden-variety recession/bear market.  Bonds go down.  Stocks go down.  The damage to stocks is worse than the damage to bonds–often by a lot.

Again, this is not the situation we’re in now.

2)  to restore money policy to normal after a period of extreme easing aimed at ending a recession or combating a severe economic shock.  That’s where we are now.

 

In situations like this, bonds go down but stocks go sideways to up.  There’s no theoretical reason I can see for the latter behavior.  It happens, I think, because, unlike the overheating situation,  the Fed doesn’t intend to bring growth down dramatically.  It just wants to wean the economy off a sugar high of very easy credit.

Two things make todaydifferent from past rate normalization periods, however:  the amount of easing has been very large and of unusually long duration; and dysfunction in the legislative and executive branches in Washington has meant fiscal policy has failed to do its part come to the country’s support, other than in the earliest days of the financial crisis.

Some argue that beause of this, today’s situation may be different enough that the past won’t be a sure guide.  I’m going with history.  But I take th point that we can’t just be on cruise control.

two different portfolio responses

The two types of tightening call for different stock portfolio construction, in my view.

In today’s world:

–bond-like stocks will probably not do well.  Years of ultra-low interest rates have forced Baby  Boomers to search for income in the stock market.  As rates rise, and bonds become increasingly attractive, some Baby Boom money will return to bonds.  At first, the reverse flow may only be new money.  At some point, however, Boomers may begin to liquidate their income stocks.

–rising rates may make the dollar spike.  In fact, the IMF recently expressed this fear in an emphatic plea to the Fed to postpone the start of the rate normalization process into 2016.  It’s not clear to me that the dollar will appreciate much further, however.  But if it does, stocks with foreign exposure will become less attractive, since the dollar value of their foreign earning power declines.  On the other hand, foreign companies with large US exposure become more attractive, both to local investors and to you and me.

–companies with their own special growth story become more attractive than those that are mostly dependent on the general business cycle for their oomph.  Cloud computing and Millennial favorites should be relatively fertile fields.  Arguably, the market’s preference for growth stocks over value has been in place for some time.  But the preference for the former should intensify.

 

More tomorrow.